An option-based product is structured on a zero coupon bond plus portfolio call option, giving a participation in the underlying portfolio which is fixed at launch with a formula linked to the volatility of the call and the zero rate. The higher the implied volatility of the call option and the lower the interest rate, the lower the participation in the underlying product.
Therefore, as Deutsche Bank’s Charles Hopkinson-Woolley explains: “The level of interest rates will only affect the product by impacting the secondary market price.”
Options-based structures are expensive he adds, “Because the implied volatilities (used to price hedge fund options) are quite high, due to a number of factors, but mainly the lack of liquidity in the options and the lack of liquidity and transparency of the underlying funds.”
The current, low interest rate environment, permits a low ‘up to 65%’ participation rate at the moment, with 80% invested in zero coupon bonds, giving the investor a high initial sensitivity to interest rates. Thus, says Lehman Brothers’‚ Jean-Marc Spitalier: “The alternative, the dynamic allocation‚ offers an appealing 100% indexation, with an annual cost of 1 to 2% per annum, depending on the structure and managers.”
The difference in participation rates is explained by the structure’s relationship to the underlying volatility of the fund. With an option-based structure, the client might pay a premium based on implied volatility of, say, 18%. Yet the volatility of the portfolio might realistically be more like 5% or 6%. The client therefore overpays (unless the structuring bank gets it wrong) for a volatility hedge.
With a constant proportion portfolio insurance (CPPI) structure, the client pays actual rather than implied volatility; there is no volatility hedge. “With CPPI, you let the thing have its own life, knowing that if volatility is high, you lose,” says Spitalier.
The other costs to the buyer of a CPPI structure are the magnitude of the gearing factor (the higher it is, the more expensive the product is likely be for the investor) and the frequency of rebalancing (the more often it is done, the more expensive the true cost of the product). “Remember, the true cost of a CPPI structure is not just the issuer’s fee, but the cost of buying high and selling low within the structure,” says Hopkinson-Woolley.
In a CPPI structure, the portfolio’s assets are divided between the risky asset (the investment level in the hedge fund asset) and a risk free asset (the zero) based on the difference between the NAV and the reference level, which is itself determined by the value of the zero. The closer is the NAV to the reference level, the lower the appetite for risk and the lower the investment level. The further is the NAV from the reference level, the greater the appetite for risk and the higher the investment level. (The formula used to determine the investment level is (NAV - reference level) x gearing factor NAV, the gearing factor being a constant and usually selected to give an investment level of 100% at launch). Given full investment at inception, there should be a one-to-one relationship between the change in price of the notes versus the hedge fund basket.
You can check by asking the bank for the delta (sensitivity of the note to the variation of the hedge fund basket), which ideally should be 100% for dynamic allocation structures, says Spitalier. Option based structures will typically start at only 50%.
A traditional CPPI structure will be doubly impacted by shifts in the yield curve. Because the floor is determined by the mark to market price of a zero coupon bond of the product’s maturity, a fall in interest rates at that point on the yield curve will cause the zerocoupon to rise, reducing the gap between NAV and floor and reducing the investment level. The product’s secondary market price may also change.
This double sensitivity has caused so many CPPI products to hit their divestment triggers, or have participations so low that it is almost impossible for them to recover.
As a result bankers such as Spitalier and Hopkinson- Woolley now tend to modify CPPI structures with a frozen interest rate curve.
However, the secondary market value of the product will still change, usually by more than an equivalent traditional CPPI product.
The other difference between the two products lies in the shape of the yield curve. If one month rates are higher than, say, five year rates, then the risk-free pot of the modified CPPI fund will be growing at a faster rate than the zero coupon bond in the traditional CPPI.
This might enable a de-leveraged modified CPPI product to increase its investment level.

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