Structured Product vs. CPPI

Bendt Böhwadt Iversen & Majken Bilslev-Jensen

Student thesis: Master thesis


two investment strategies, both comprising an element of protection. We have considered the investment options from a private investor perspective. The strategies in question were structured products (SPs) and constant proportional portfolio insurance (CPPI). On a structural level the strategies differ in the way they offer exposure and upside potential as well as how they protect the principal investment. The SPs combination of derivatives and zero coupon bonds provides the issuers and developers with an unprecedented opportunity to engineer exotic constructions with great marketing potential. On the negative side such products often suffer from high costs, low average performance and poor transparency. These attributes places them on the edge of what is, among experts, considered suitable for private investors. The high cost is primarily a result of several financial service providers participation in the development of the product as well as possible opportunistic behavior among these different parties. We took up the CPPI strategy as a "do it yourself" replication of the protection and the upside potential offered in the prepackaged SPs. Comprising only traditional assets such as stocks, cash and bonds the assets in the CPPI are alternatives within reach of the private investor. However this strategy can easily prove immensely time-consuming and sudden market corrections can potentially jeopardize the fundamental principal protection. Subsequent to the general comparisons of the strategies we moved on to evaluate the relative performance of Dexia Basis a SP offered by Belgium Dexia Bank and a CPPI strategy with the same underlying assets. This was performed in two stages; first considering the realized period between 2002 and 2007 then followed by simulation scenarios introducing different models and volatility schemes including: Geometric Brownian motion, Merton’s jump-diffusion model and Heston model. The CPPI showed superior performance through all scenarios presented. The annual base case performance of the CPPI in the three above mentioned models were in excess of 2.88 percentage points higher than the SP. The overall results were not affected by sensitivity analysis, however the analysis revealed different behavior when the volatility was changed in high, base and low scenarios. The SP showed increasing positive performance due to the option component in the product whereas the CPPI was negatively affected due to the need for more cost generating rebalancing actions and more importantly an added chance of gap risk and cash lock situations. Further tests were conducted to determine the main drivers of large divergence in returns between the two strategies. Raising the costs of operating the CPPI to align with the SP lowered the return to an extend where only 1.55 percentage points separated the strategies with the CPPI still yielding the highest return. One of the most common points of criticism we found during our general research on SPs was the accusation against option issuers selling the options used in SPs at a high price. To test whether this was also the case with Dexia Basis we estimated a "fair" price of the option. The new price was lower and increased the SP participation rate with close to 10 percentage points from 73% to 82.7%. The new annual result went up by approximately 0.65 percentage points meaning that the SP was still severely underperforming compared to the CPPI. Given the specific assumptions underlying our comparisons of the SP and CPPI we concluded that the CPPI by a large margin demonstrate the strongest alternative of the two.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2009
Number of pages99