THEORY OF CONSTANT PROPORTION PORTFOLIO INSURANCE

We study constant proportion portfolio insurance (CPPI), a dynamic strategy that maintains the portfolio's risk exposure a constant multiple of the excess of wealth over a floor, up to a borrowing limit. We use this simple rule to investigate how transaction costs and borrowing constraints affect portfolio insurance-type strategies. Absent transaction costs, CPPI is equivalent to investing in perpetual American call options, and is optimal for a piecewise-HARA utility function with a minimum consumption constraint. As the multiple increases, the payoffs under CPPI approach those of a stop-loss strategy. The expected holding-period return is not monotonic in the multiple, and a higher expected return can be obtained under CPPI than with a stop-loss strategy.