Alternative Investments and Strategies

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Library of Congress Cataloging-in-Publication Data

Alternative investments and strategies / edited by Rüdiger Kiesel, Matthias Scherer & Rudi Zagst.
p. cm.
ISBN-13: 978-9814280105
ISBN-10: 9814280100
1. Investments--Moral and ethical aspects. 2. Portfolio management--Moral and ethical aspects.
I. Kiesel, Rüdiger, 1962– II. Scherer, Matthias. III. Zagst, Rudi, 1961–
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2010013167
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PREFACE
Asset allocation investigates the optimal division of a portfolio among different asset
classes. Standard theory involves the optimal mix of risky stocks, bonds, and cash
together with various subdivisions of these asset classes. Underlying this is the insight
that diversification allows for achieving a balance between risk and return: by using
different types of investment, losses may be limited and returns are made less volatile
without losing too much potential gain.
These insights are made precise using the benchmark theory of mathematical
finance, the Black-Scholes-Merton theory, based on Brownian motion as the driving
noise process for risky asset prices. Here, the distributions of financial returns of the
risky assets in a portfolio are multivariate normal, thus relating to the standard mean-
variance portfolio theory of Markowitz with its risk-return paradigm as above.
Recent years have seen many empirical studies shedding doubt on the Black-
Scholes-Merton model, and motivating various alternative modeling approaches,
which were able to reproduce the stylized facts of asset returns (such as heavy tails and
volatility clustering) much better. Also, various new asset classes and specific financial
tools for achieving better diversification have been created and entered the investment
universe.
This book combines academic research and practical expertise on these new (often
called alternative) assets and trading strategies in a unique way. We include the prac-
titioners’ viewpoint on new asset classes as well as academic research on modeling
approaches, for new asset classes. In particular, alternative asset classes such as power
forward contracts, forward freight agreements, and investment in photovoltaic facil-
ities are discussed in detail, both on a stand-alone basis and with a view to their
effects on diversification in combination with classical asset. We also analyse credit-
related portfolio instruments and their effect in achieving an optimal asset allocation.
In this context, we highlight aspects of financial structures which may sometimes be
neglected, such as default risk of issuer in case of certificates or the role that model
v
vi Preface
risk plays within asset allocation problems. This leads naturally to the use of robust
asset allocation strategies.
Extending the classical mean-variance portfolio setting, we include dynamic port-
folio strategies and illustrate different portfolio protection strategies. In particular, we
compare the benefits of such strategies and investigate conditions under which Con-
stant Proportion Portfolio Insurance (CPPI) may be prefered to Option-Based Portfolio
Insurance (OBPI) and vice versa. We also contribute to the understanding of gap risk
by analyzing this risk for CPPI and Constant Proportion Debt Obligations (CPDO) in
a sophisticated modeling framework. Such analyses are supplemented and extended
by an investigation of the optimality of hedging approaches such as variance-optimal
hedging and semistatic variants of classical hedging strategies.
Many of the articles can serve as guides for the implementation of various models.
In addition, we also present state-of-the-art models and explain modern tools from
financial mathematics, such as Markov-Switching models, time-changed Lévy models,
variants of lognormal approximations, and copula structures.
This books combines a unique mix of authors. Also many of our students improved
the outcome of the project with critical and insightful comments. Particular thanks goes
to Georg Grüll, Peter Hieber, Julia Kraus, Matthias Lutz, Jan-Frederik Mai, Kathrin
Maul, Kevin Metka, Daniela Neykova, Johannes Rauch, Andreas Rupp, Daniela Selch,
and Christofer Vogt.
R. Kiesel, M. Scherer, and R. Zagst

CONTENTS
Preface v
Part I. Alternative Investments

Chapter 1. Socially Responsible Investments 3
Sven Hroß, Christofer Vogt and Rudi Zagst
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2 Recent Research on SRI . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3 How Sustainable is Sustainability? . . . . . . . . . . . . . . . . . . . . . 6
1.3.1 Description of the Dataset . . . . . . . . . . . . . . . . . . . . . 6
1.3.2 Introduction to Markov Transition Matrices . . . . . . . . . . . . 6
1.3.3 Results of Markov Transition Matrices . . . . . . . . . . . . . . 7
1.4 SRI in Portfolio Context . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.4.1 Description of the Dataset and Statistical Properties . . . . . . . 8
1.4.2 Markov-Switching Model . . . . . . . . . . . . . . . . . . . . . 11
1.4.3 Fitting the Model Parameters . . . . . . . . . . . . . . . . . . . 11
1.4.4 Simulation of Returns . . . . . . . . . . . . . . . . . . . . . . . 13
1.4.5 Portfolio Optimization Models . . . . . . . . . . . . . . . . . . 13
1.4.6 Definition of Investor Types . . . . . . . . . . . . . . . . . . . . 15
1.4.7 Optimal Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . 15
1.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Chapter 2. Listed Private Equity in a Portfolio Context 21

Philipp Aigner, Georg Beyschlag, Tim Friederich,
Markus Kalepky and Rudi Zagst
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.2 Defining Private Equity Categories . . . . . . . . . . . . . . . . . . . . . 23
2.2.1 Financing Stages . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.2.2 Divestment Strategies . . . . . . . . . . . . . . . . . . . . . . . 24
vii
viii Contents
2.2.3 Type of Financing . . . . . . . . . . . . . . . . . . . . . . . . . 25

2.2.4 Classification of Private Equity Fund Investments . . . . . . . . 26
2.2.4.1 Venture capital funds . . . . . . . . . . . . . . . . . . . 26
2.2.4.2 Buyout funds . . . . . . . . . . . . . . . . . . . . . . . 27
2.2.4.3 Leveraged buyouts (LBO) . . . . . . . . . . . . . . . . 27
2.3 Investment Possibilities — One Asset, Many Classes . . . . . . . . . . . 28
2.3.1 Direct Investments . . . . . . . . . . . . . . . . . . . . . . . . . 28
2.3.2 Private Equity Funds . . . . . . . . . . . . . . . . . . . . . . . . 29
2.3.2.1 Key players . . . . . . . . . . . . . . . . . . . . . . . 29
2.3.3 Cash Flow Structure of a Private Equity Fund . . . . . . . . . . . 31
2.3.4 Fund-of-Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
2.3.4.1 Structure of a private equity fund-of-funds . . . . . . . 32
2.3.4.2 Advantages . . . . . . . . . . . . . . . . . . . . . . . . 32
2.3.4.3 Disadvantages . . . . . . . . . . . . . . . . . . . . . . 33
2.3.5 Publicly Traded Private Equity . . . . . . . . . . . . . . . . . . 33
2.3.6 Secondary Transactions . . . . . . . . . . . . . . . . . . . . . . 34
2.3.6.1 Types of secondary transactions . . . . . . . . . . . . . 34
2.3.6.2 Buyer’s motivation . . . . . . . . . . . . . . . . . . . . 35
2.4 Private Equity as Alternative Asset Class
in an Investment Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.4.1 Characteristics of LPE Return Series . . . . . . . . . . . . . . . 36
2.4.2 Modeling Return Series with Markov-Switching Processes . . . . 37
2.4.2.1 Markov–Switching models . . . . . . . . . . . . . . . 37
2.4.2.2 Fitting the parameters . . . . . . . . . . . . . . . . . . 39
2.4.2.3 Simulation of return paths . . . . . . . . . . . . . . . . 40
2.4.3 Listed Private Equity in Asset Allocation . . . . . . . . . . . . . 40
2.4.3.1 Performance measurement . . . . . . . . . . . . . . . . 40
2.4.3.2 Portfolio optimization frameworks . . . . . . . . . . . 42
2.4.3.3 Definition of investor types . . . . . . . . . . . . . . . 43
2.4.3.4 Optimization of portfolios . . . . . . . . . . . . . . . . 44
2.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Chapter 3. Alternative Real Assets in a Portfolio Context 51

Wolfgang Mader, Sven Treu and Sebastian Willutzky
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
3.2 Overview on Alternative Real Assets . . . . . . . . . . . . . . . . . . . . 52
3.3 Modeling Photovoltaic Investments . . . . . . . . . . . . . . . . . . . . 53
3.3.1 General Approach . . . . . . . . . . . . . . . . . . . . . . . . . 53
3.3.2 Definition of the Investment Project . . . . . . . . . . . . . . . . 54
Contents ix
3.3.3 Modeling of Risk Factors . . . . . . . . . . . . . . . . . . . . . 56

3.3.3.1 Economic factors . . . . . . . . . . . . . . . . . . . . 56
3.3.3.2 Non-economic factors . . . . . . . . . . . . . . . . . . 57
3.3.3.3 Historical analysis of monthly global irradiance . . . . 58
3.3.3.4 Monte Carlo analysis of yearly global irradiance . . . . 61
3.4 Photovoltaic Investments in a Portfolio Context . . . . . . . . . . . . . . 63
3.4.1 Setting the Portfolio Context . . . . . . . . . . . . . . . . . . . . 63
3.4.2 Including Photovoltaic Investments in a Portfolio . . . . . . . . . 64
3.4.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Chapter 4. The Freight Market and Its Derivatives 71

Rüdiger Kiesel and Patrick Scherer
4.1 Introduction: the Freight Market . . . . . . . . . . . . . . . . . . . . . . 72
4.1.1 Vessels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
4.1.2 Cargo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
4.1.3 Routes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.2 Freight Rates: What Drives the Market? . . . . . . . . . . . . . . . . . . 74
4.2.1 Demand for Shipping Capacity . . . . . . . . . . . . . . . . . . 75
4.2.2 Supply of Shipping Capacity . . . . . . . . . . . . . . . . . . . 76
4.2.3 Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.3 Freight Derivatives: Hedging or Speculating? . . . . . . . . . . . . . . . 77
4.3.1 Forward Freight Agreement . . . . . . . . . . . . . . . . . . . . 77
4.3.2 Freight Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
4.4 Explanatory Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
4.4.1 Explanatory Power . . . . . . . . . . . . . . . . . . . . . . . . . 80
4.4.2 Granger Causality . . . . . . . . . . . . . . . . . . . . . . . . . 82
4.4.3 Selection Algorithm “Top Five” . . . . . . . . . . . . . . . . . . 83
4.4.4 Cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
4.5 Predicting Freight Spot and Futures Rates . . . . . . . . . . . . . . . . . 86
4.6 The Backtesting Algorithm . . . . . . . . . . . . . . . . . . . . . . . . . 88
4.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Chapter 5. On Forward Price Modeling in Power Markets 93

Fred Espen Benth
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
5.2 HJM Approach to Power Forward Pricing . . . . . . . . . . . . . . . . . 95
5.3 Power Forwards and Approximation by Geometric
Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
x Contents
5.3.1 A Geometric Brownian Motion Dynamics

by Volatility Averaging . . . . . . . . . . . . . . . . . . . . . . . 101
5.3.2 A Geometric Brownian Motion Dynamics
by Moment Matching . . . . . . . . . . . . . . . . . . . . . . . 103
5.3.3 The Covariance Structure Between Power Forwards . . . . . . . 106
5.3.4 The Distribution of a Power Forward . . . . . . . . . . . . . . . 108
5.3.5 Numerical Analysis of the Power Forward Distribution . . . . . . 110
5.4 Pricing of Options on Power Forwards . . . . . . . . . . . . . . . . . . . 114
5.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Chapter 6. Pricing Certificates Under Issuer Risk 123

Barbara Götz, Rudi Zagst and Marcos Escobar
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
6.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
6.3 Pricing of Certificates Under Issuer Risk . . . . . . . . . . . . . . . . . . 126
6.3.1 Building Blocks . . . . . . . . . . . . . . . . . . . . . . . . . . 126
6.3.2 Index Certificates . . . . . . . . . . . . . . . . . . . . . . . . . 130
6.3.3 Participation Guarantee Certificates . . . . . . . . . . . . . . . . 132
6.3.4 Bonus Guarantee Certificates . . . . . . . . . . . . . . . . . . . 134
6.3.5 Discount Certificates . . . . . . . . . . . . . . . . . . . . . . . . 135
6.3.6 Bonus Certificates . . . . . . . . . . . . . . . . . . . . . . . . . 136
6.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
Chapter 7. Asset Allocation with Credit Instruments 147

Barbara Menzinger, Anna Schlösser and Rudi Zagst
7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
7.2 Simulation Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
7.3 Framework for Total Return Calculation . . . . . . . . . . . . . . . . . . 153
7.4 Optimization Framework . . . . . . . . . . . . . . . . . . . . . . . . . . 156
7.4.1 Mean-Variance Optimization . . . . . . . . . . . . . . . . . . . 156
7.4.2 CVaR Optimization . . . . . . . . . . . . . . . . . . . . . . . . 157
7.5 Model Calibration and Simulation Results . . . . . . . . . . . . . . . . . 157
7.5.1 Mean-Variance Approach . . . . . . . . . . . . . . . . . . . . . 162
7.5.2 Conditional Value at Risk . . . . . . . . . . . . . . . . . . . . . 164
7.5.3 Comparison of Selected Optimal Portfolios . . . . . . . . . . . . 167
7.6 Summary and Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . 170
Chapter 8. Cross Asset Portfolio Derivatives 175

Stephan Höcht, Matthias Scherer and Philip Seegerer
Contents xi
8.1 Introduction to Cross Asset Portfolio Derivatives . . . . . . . . . . . . . 175

8.1.1 Definitions and Examples . . . . . . . . . . . . . . . . . . . . . 176
8.2 Collateralized Obligations . . . . . . . . . . . . . . . . . . . . . . . . . 179
8.3 A Comparison of CFO with CTSO . . . . . . . . . . . . . . . . . . . . . 179
8.3.1 Structural Features of CFO . . . . . . . . . . . . . . . . . . . . 179
8.3.2 Structural Features of CTSO . . . . . . . . . . . . . . . . . . . . 181
8.3.3 The Different Risks . . . . . . . . . . . . . . . . . . . . . . . . 181
8.3.4 Correlation of Tail Events in CTSO . . . . . . . . . . . . . . . . 181
8.4 Pricing Cross Asset Portfolio Derivatives . . . . . . . . . . . . . . . . . 182
8.4.1 Pricing Trigger Swaps . . . . . . . . . . . . . . . . . . . . . . . 182
8.4.2 Pricing nth-to-Trigger Baskets . . . . . . . . . . . . . . . . . . . 183
8.4.3 Pricing CTSO . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
8.4.4 Modeling Approaches . . . . . . . . . . . . . . . . . . . . . . . 185
8.4.4.1 The structural approach . . . . . . . . . . . . . . . . . 185
8.4.4.2 The copula approach . . . . . . . . . . . . . . . . . . . 186
8.4.5 An Example for an nth-to Trigger Basket . . . . . . . . . . . . . 188
8.4.5.1 A pricing exercise of Example 3
(structural approach) . . . . . . . . . . . . . . . . . . 188
8.4.5.2 A pricing exercise of Example 3
(copula approach) . . . . . . . . . . . . . . . . . . . . 189
8.4.5.3 Resulting model spreads . . . . . . . . . . . . . . . . . 190
8.5 Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
8.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
Part II. Alternative Strategies

Chapter 9. Dynamic Portfolio Insurance Without Options 201
Dominik Dersch
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
9.2 Simple Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
9.2.1 Buy-and-Hold . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
9.2.2 Stop-Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
9.2.3 The Bond Floor Strategy . . . . . . . . . . . . . . . . . . . . . . 204
9.2.4 Plain Vanilla CPPI . . . . . . . . . . . . . . . . . . . . . . . . . 205
9.3 Historical Simulation I . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
9.4 Advanced Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
9.4.1 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . 210
9.4.2 Transaction Filter . . . . . . . . . . . . . . . . . . . . . . . . . 210
9.4.3 Lock-in Levels . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
xii Contents
9.4.4 Leverage and Constrain of Exposure . . . . . . . . . . . . . . . 212

9.4.5 Rebalancing Strategies for the Risky Portfolio . . . . . . . . . . 213
9.4.6 CPPI and Beyond . . . . . . . . . . . . . . . . . . . . . . . . . 213
9.5 Historical Simulation II . . . . . . . . . . . . . . . . . . . . . . . . . . 214
9.5.1 Transaction Costs and Transaction Filter . . . . . . . . . . . . . 214
9.5.2 Lock-in Levels . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
9.5.3 The Use of Leverage . . . . . . . . . . . . . . . . . . . . . . . . 220
9.5.4 CPPI on a Multi-Asset Risky Portfolio . . . . . . . . . . . . . . 222
9.6 Implement a Dynamic Protection Strategy with ETF . . . . . . . . . . . 223
9.7 Closing Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
Chapter 10. How Good are Portfolio Insurance Strategies? 227

Sven Balder and Antje Mahayni
10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
10.2 Optimal Portfolio Selection with Finite Horizons . . . . . . . . . . . . . 230
10.2.1 Problem (A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
10.2.2 Problem (B) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
10.2.3 Problem (C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
10.2.4 Comparison of Optimal Solutions . . . . . . . . . . . . . . . . . 238
10.3 Utility Loss Caused by Guarantees . . . . . . . . . . . . . . . . . . . . . 242
10.3.1 Justification of Guarantees and Empirical Observations . . . . . 242
10.3.2 Utility Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
10.4 Utility Loss Caused by Trading Restrictions
and Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
10.4.1 Discrete-Time CPPI . . . . . . . . . . . . . . . . . . . . . . . . 246
10.4.2 Discrete-Time Option-Based Strategy . . . . . . . . . . . . . . . 249
10.4.3 Comments on Utility Loss and Shortfall Probability . . . . . . . 250
10.5 Utility Loss Caused by Guarantees
and Borrowing Constraints . . . . . . . . . . . . . . . . . . . . . . . . . 252
10.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
Chapter 11. Portfolio Insurances, CPPI and CPDO, Truth or Illusion? 259
Elisabeth Joossens and Wim Schoutens
11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
11.2 Credit Risk and Credit Default Swaps . . . . . . . . . . . . . . . . . . . 261
11.2.1 Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
11.2.2 Credit Default Swaps (CDS) . . . . . . . . . . . . . . . . . . . . 265
11.3 Portfolio Insurances . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
Contents xiii
11.4 Modeling of CPPI Dynamics Using Multivariate

Jump-Driven Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
11.4.1 Multivariate Variance Gamma Modeling . . . . . . . . . . . . . 270
11.4.2 Swaptions on Credit Indices . . . . . . . . . . . . . . . . . . . . 273
11.4.2.1 Black’s model . . . . . . . . . . . . . . . . . . . . . . 273
11.4.2.2 The variance gamma model . . . . . . . . . . . . . . . 274
11.4.3 Spread Modeling by Correlated VG Processes . . . . . . . . . . 275
11.4.3.1 The pricing of CPPIs . . . . . . . . . . . . . . . . . . . 275
11.4.3.2 Gap risk . . . . . . . . . . . . . . . . . . . . . . . . . 279
11.5 Recent Developments for CPPI . . . . . . . . . . . . . . . . . . . . . . 281
11.5.1 Portfolio Insurance: The Extreme Value Approach
to the CPPI Method . . . . . . . . . . . . . . . . . . . . . . . . 282
11.5.2 VaR Approach for Credit CPPI . . . . . . . . . . . . . . . . . . 283
11.5.3 CPPI with Cushion Insurance . . . . . . . . . . . . . . . . . . . 284
11.6 A New Financial Instrument: Constant Proportion Debt Obligations . . . 285
11.6.1 The Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
11.6.2 CPDOs in the Spotlight . . . . . . . . . . . . . . . . . . . . . . 289
11.6.3 Rating CPDOs Under VG Dynamics . . . . . . . . . . . . . . . 289
11.7 Comparison Between CPPI and CPDO . . . . . . . . . . . . . . . . . . 291
11.8 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Chapter 12. On the Benefits of Robust Asset Allocation for CPPI Strategies 295
Katrin Schöttle and Ralf Werner
12.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
12.2 The Financial Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
12.2.1 The Basic Financial Market . . . . . . . . . . . . . . . . . . . . 297
12.2.2 The Riskless Asset . . . . . . . . . . . . . . . . . . . . . . . . . 298
12.2.3 The Risky Asset . . . . . . . . . . . . . . . . . . . . . . . . . . 298
12.2.4 Classical Mean–Variance Analysis . . . . . . . . . . . . . . . . 300
12.2.5 The Trading Strategy . . . . . . . . . . . . . . . . . . . . . . . . 302
12.3 The Standard CPPI Strategy . . . . . . . . . . . . . . . . . . . . . . . . 302
12.3.1 The Simple Case . . . . . . . . . . . . . . . . . . . . . . . . . . 303
12.3.2 The General Case . . . . . . . . . . . . . . . . . . . . . . . . . 305
12.3.3 Shortfall Probability of CPPI Strategies . . . . . . . . . . . . . . 308
12.3.4 Improving CPPI Strategies . . . . . . . . . . . . . . . . . . . . . 310
12.3.5 CPPI Strategies Under Estimation Risk . . . . . . . . . . . . . . 313
12.4 Robust Mean–Variance Optimization and Improved CPPI Strategies . . . 316
12.4.1 Robust Mean–Variance Analysis . . . . . . . . . . . . . . . . . . 317
12.4.2 Uncertainty Sets Via Expert Opinions or Related Estimators . . . 317
xiv Contents
12.4.3 Uncertainty Sets Via Confidence Sets . . . . . . . . . . . . . . . 319

12.4.4 Usage and Implications for CPPI Strategies . . . . . . . . . . . . 321
12.4.5 CPPIs with Robust Asset Allocations . . . . . . . . . . . . . . . 323
12.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
Chapter 13. Robust Asset Allocation Under Model Risk 327

Pauline Barrieu and Sandrine Tobelem
13.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
13.2 A Robust Approach to Model Risk . . . . . . . . . . . . . . . . . . . . . 329
13.2.1 The Absolute Ambiguity Robust Adjustment . . . . . . . . . . . 330
13.2.2 Relative Ambiguity Robust Adjustment . . . . . . . . . . . . . . 333
13.2.3 ARA Parametrization . . . . . . . . . . . . . . . . . . . . . . . 334
13.3 Some Definitions Relative to the Ambiguity-Adjusted
Asset Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
13.4 Empirical Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
13.4.1 Portfolios Tested . . . . . . . . . . . . . . . . . . . . . . . . . . 337
13.4.2 Performance Measures . . . . . . . . . . . . . . . . . . . . . . . 339
13.4.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
13.4.3.1 Performances of the different models . . . . . . . . . . 341
13.4.3.2 SEU portfolio . . . . . . . . . . . . . . . . . . . . . . 342
13.4.3.3 Ambiguity robust portfolios . . . . . . . . . . . . . . . 342
13.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
Chapter 14. Semi-Static Hedging Strategies for Exotic Options 345

Hansjörg Albrecher and Philipp Mayer
14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
14.2 Hedging Path-Independent Options . . . . . . . . . . . . . . . . . . . . 347
14.2.1 Plain Vanilla Options with Arbitrary Strikes are Liquid . . . . . . 348
14.2.2 Finitely Many Liquid Strikes . . . . . . . . . . . . . . . . . . . 349
14.3 Hedging Barrier and Other Weakly Path Dependent Options . . . . . . . 350
14.3.1 Model-Dependent Strategies: Perfect Replication . . . . . . . . . 351
14.3.2 Model-Dependent Strategies: Approximations . . . . . . . . . . 357
14.3.3 Model-Independent Strategies: Robust Strategies . . . . . . . . . 359
14.4 Hedging Strongly Path-Dependent Options . . . . . . . . . . . . . . . . 361
14.4.1 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . 362
14.4.2 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
14.5 Case Study: Model-Dependent Hedging of Discretely
Sampled Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
14.6 Conclusion and Future Research . . . . . . . . . . . . . . . . . . . . . . 370
Contents xv
Chapter 15. Discrete-Time Variance-Optimal Hedging in Affine

Stochastic Volatility Models 375
Jan Kallsen, Richard Vierthauer, Johannes Muhle-Karbe
and Natalia Shenkman
15.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
15.2 Discrete-Time Variance-Optimal Hedging . . . . . . . . . . . . . . . . . 377
15.3 The Laplace Transform Approach . . . . . . . . . . . . . . . . . . . . . 378
15.4 Application to Affine Stochastic
Volatility Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
15.5 Numerical Illustration . . . . . . . . . . . . . . . . . . . . . . . . . . . 388
Index 395
May 12, 2010 17:46 WSPC/SPI-B913 b913-ch01 FA
Part I
Alternative Investments

SOCIALLY RESPONSIBLE
INVESTMENTS
1
SVEN HROß∗ , CHRISTOFER VOGT† and RUDI ZAGST‡
HVB-Stiftungsinstitut für Finanzmathematik,
Technische Universität München, Boltzmannstr. 3,
85747 München, Germany
∗
shross@gmx.de
†
vogtchri@aol.com
‡
zagst@tum.de
Within the last two decades, the market of socially responsible investing (SRI) has seen
unprecedented growth and has become more and more important, not only because of
the current financial crisis. This chapter gives a survey of the asset class SRI in general,
i.e., market development and investment possibilities. Moreover, the question “How
sustainable is sustainability?” is addressed by analyzing SAM Group sustainability
rankings of the years 2001–2007. Furthermore, the ability of SRI to contribute to
diversification within a portfolio is scrutinized. The analysis is based on simulated
returns generated by an autoregressive Markov-Switching model and accounts for
different levels of investors’ risk aversion. Optimal portfolios consisting of stocks,
bonds, and the respective SRI index show that risk–averse investors mix SRI to an
established portfolio consisting of bonds and stocks to reduce the risk and increase
the performance. Additionally, the asset class SRI is found to be a substitute for the
asset class stocks.
3
4 Hroß et al.
1.1. INTRODUCTION
There are different ways to describe socially responsible investing (SRI). Reference 1
defines SRI as the integration of environmental, social, and corporate governance
(ESG) considerations into investment management processes and ownership practices
hoping that these factors can have an impact on financial performance. Responsible
investment can be practiced across all asset classes.
Several reasons can be stated, why the field of SRI has gained great public interest
as well as rising economic importance in recent years. Simultaneously to the on-going
climate change debate, public scrutiny and political attention have put pressure on
businesses to consider both social and environmental issues in their activities.
Accompanied by these developments, the SRI market grew strongly during the last
decade. SRI does no longer represent a negligible economical niche, but as stated in [2]
it might play a crucial financial role in the future. The current size of the worldwide
SRI market is according to [3] approximately 5 trillion. With 53% market share, the
greatest part of the SRI market is based in Europe followed by the United States with
39%. The rest of the world represents only 8% of the SRI market.
According to [4], the size of the SRI market in the United States was $639 bil-
lion in 1995 and then grew up to $2159 billion in 1999, which means an average
annual growth rate of 36%. From 1999 to 2005, SRI investment volumes only slightly
grew up to $2290 billion, but then growth accelerated again resulting in $2711 billion
in 2007.
The European SRI market experienced an average growth rate of 51% since 2002
from an absolute investment volume of 336 billion in 2002 up to 2665 billion in
2007. Reference 3 estimates that the share of SRI in the total European fund market is
about 17.6% in 2008 and largely driven by institutional investors.
There are several possibilities to invest into SRI. For example, the SAM Group
(www.sam-group.com) offers a wide range of funds covering the total SRI market and
also special funds, e.g., on Islamic sustainability. There are also sustainably managed
fixed-income funds available. Another possibility is the direct investment into non-
listed companies or projects. In this context, projects like wind farms or solar parks can
be mentioned as suitable investment possibilities. Moreover, certificates are available
on the market which allow the investor to participate in the SRI market, e.g., index
certificates on the European Renewable Energy Index (ERIX Index Certificate, Societe
Generale, ISIN: DE000SG1ERX7).
The structure of this chapter is as follows. Section 1.2 gives an overview on recent
research on SRI. Section 1.3 answers the question “How sustainable is sustainability?”
by using Markov transition matrices. Section 1.4 then analyzes SRI in a portfolio con-
text by generating optimal portfolios for different investors using a Markov-Switching
model and different optimization frameworks. Finally, Sec. 1.5 concludes.
Socially Responsible Investments 5
1.2. RECENT RESEARCH ON SRI
During the last years, several empirical studies analyzed whether SRI produces or
destroys shareholder wealth. Many early studies on the performance of SRI use regres-
sion models with one or two factors and try to measure Jensen’s alpha. Reference 5
compares 32 SRI funds to 320 non-SRI funds in the United States between 1981 and
1990 and finds no significant average alphas with respect to a value-weighted NYSE
index. More advanced studies apply a matching approach to compare SRI and non-SRI
funds with similar characteristics, e.g., fund universe and size. Within this approach,
management and transaction costs can be included into the analysis, see, e.g., [6]
or [7]. As a result, no significant performance differences between SRI and non-SRI
could be observed. One problem is that important characteristics might not be taken
into consideration. Reference 8 applies a four factor model according to [9] using as
regression factors the excess market return, SMB (“Small-minus-Big”: The difference
between the return of a small- and of a large-cap portfolio), HML (“High-minus-Low”:
The return difference between a value- and a growth-portfolio, i.e., a portfolio con-
taining firms that dispose of a high book-to-market ratio versus firms with a low value
relating to this ratio), and MOM (“Momentum”: The return difference betweeen two
portfolios, one consisting of last year’s best performers and the other of the worst
performers) in order to analyze the performance of United States, German, and British
SRI funds. The authors build two portfolios for each country, one containing all SRI
funds, the other the conventional funds, and find under — as well as outperformance of
SRI, but none of the differences are significant. Furthermore, SRI funds seem to have
an investment bias toward growth stocks (low book-to-market value) and small caps
(lower market-capitalization). Reference 10 uses eco-efficiency rankings of Innovest
to evaluate two equity portfolios that differ in eco-efficiency. The high-ranked portfo-
lio shows significantly higher returns than its low-ranked counterpart over the period
1995–2003. In contrast, [11] finds that SRI investors have to pay for their constrained
investment style. Another approach is to look at SRI equity indices to avoid usual prob-
lems of mutual funds during a performance analysis, e.g., transaction costs of funds
or effects of management skills. Reference 12 analyzes 29 SRI indices and applies
different settings to test for differences in risk-adjusted performance compared to a
suitable benchmark. The study concludes that SRI screens do not lead to significant
performance difference of SRI indices. Yet, no final answer to the question whether
SRI produces or destroys shareholder wealth can be given. Independent of these find-
ings, SRI market growth might simply come from the non-financial utility gained by
SRI investors. To the authors’ best knowledge, there is yet no such study scrutinizing
this effect. Therefore, the focus of Sec. 1.4 lies on the benefits of SRI in a portfolio
context. For this, optimal portfolios of bonds, stocks, and SRI will be constructed for
different investor types and in different optimization frameworks.
6 Hroß et al.
1.3. HOW SUSTAINABLE IS SUSTAINABILITY?
In this section, the endurance of sustainability is analyzed. This is especially important

for an SRI investor, who does not want to have too many reallocations in his portfolio.
Moreover, sustainability scores should be enduring by the pure definition of the word
“sustainability”. For this aim, sustainability scores from SAM Group, one of the world’s
most respected companies in the field of SRI assessment, are scrutinized. This study
is implemented using Markov transition matrices.
1.3.1. Description of the Dataset

The dataset used for the analysis contains the sustainability scores (hereinafter called
total score) of 822 companies. The methodology for calculating the total score of a
firm is given as follows. A company’s economic, ecologic, and social performance is
analyzed, where each of the three dimensions is divided into several criteria. These cri-
teria are weighted with an individual percentage of contribution to derive the final total
score. There are general criteria for all industries and specific criteria for companies
in a certain sector.
The complete dataset consists of 4432 total scores for the different firms and years
between 2001 and 2007. However, not every company receives a sustainability score
by SAM every year, simply due to the fact that there are firms that are not willing to
participate in the assessment process every year. To be more precise, only 185 com-
panies were evaluated by SAM Group in every single of the seven assessment years.
The companies in the dataset are a mixture of worldwide well-known multinational
companies, such as Adidas AG, Allianz SE, the Coca-Cola Company, and Sony Cor-
poration, as well as rather regional established firms such as Eniro AB from Sweden
or the Italian Beni Stabili SpA. It can be seen from Table 1.1 that the total scores
over the whole time period range between a rather low rating of 4.97 and a very high
score of 92.37, i.e., that the predefined range between 0 and 100 is actually utilized.
Interestingly, the median and mean of the overall total scores are slightly above 50,
and barely half of the companies received a sustainability score between 43 and 65.
1.3.2. Introduction to Markov Transition Matrices

In this section, Markov transition matrices are used to analyze the evolution of the
sustainability scores. A high degree of variation within the total scores would be
Table 1.1 Statistics on Total Score.

Minimum 1st quartile Median Mean 3rd quartile Maximum
4.97 43.60 55.48 53.67 65.19 92.37
counter-intuitive, due to the fact that sustainability is a long-term affair and thus should
not be subject to large-sized jumps, unless extraordinary events occur, e.g., an envi-
ronmental disaster on an oil producer’s platform. For the following analysis, data of
those companies are used for which the sustainability scores are available for two
consecutive years. For the entire six-year time period, this leads to a total dataset of
2125 observations. The calculation of the transition matrices is performed as follows:
For every single year, companies are ranked by their sustainability score, whereby for
every year the 25% best rated companies are assigned to the 1st quartile, the next 25%
to the 2nd quartile, and so on. Based on this allocation, empirical transition probabil-
ities from one of the four quartiles to any of the four quartiles after one year can be
calculated.
1.3.3. Results of Markov Transition Matrices

From the average one-year transition probabilities in Table 1.2, it can be seen that the
probability of staying in the current quartile is the highest and ranges from 47.53% for
the 2nd quartile to 72.21% for the last quartile.Additionally, the probability decreases in
the distance between two quartiles. Furthermore, the probability that a top-ranked firm
will end up in the 4th quartile in the following year is only 0.37% and the probability
of a “bad” company to be part of the first quartile in the following period is 1.23%.
Moreover, Markov transition matrices for every single year 2001–2007 were scru-
tinized. The results for the single years are quite similar to the average observation in
Table 1.2. Finally, a six-year Markov transition matrix was computed. The results are
shown in Table 1.3.
Nearly half of the companies that were ranked in the first quartile in 2001 were
still in the first quartile in 2007. The probability that a highly sustainable company will
be part of the worst quartile at the end of the six years is 5.36% and the probability
of the opposite case, i.e., a “bad” company ending as a sustainability leader after six
years, is 7.02%.
Table 1.2 Average One-Year Markov Transition Proba-

bilities (Year 2001–2007).
Next year quartile
1 (%) 2 (%) 3 (%) 4 (%)
1 69.74 25.00 4.90 0.37

2 23.83 47.53 24.35 4.29
Last year quartile
3 5.15 21.74 49.94 23.17
4 1.23 5.96 20.60 72.21
8 Hroß et al.
Table 1.3 Markov Six-Year Transition Probabilities

(Year 2001–2007).
Next year quartile

1 (%) 2 (%) 3 (%) 4 (%)
1 46.43 26.79 21.43 5.36

2 25.00 39.29 32.14 3.57
Last year quartile
3 21.43 14.29 32.14 32.14
4 7.02 19.30 14.04 59.65
Altogether, the results provide evidence to the assumption that sustainability rank-
ings do not have a high degree of short-term variation.
1.4. SRI IN PORTFOLIO CONTEXT
After having analyzed the sustainability of sustainability in the preceding section, this
section will scrutinize how SRI can be evaluated with regard to the portfolio context.
The main questions to be answered are whether investors shall add SRI investments
to their portfolio, and if so, with which weighting.
In the conducted portfolio case study, the SRI market is represented by the
Advanced Sustainable Performance Index (ASPI). The ASPI is a European index con-
sisting of 120 companies and is published by Vigeo Group, an extra-financial supplier
and rating agency in the field of sustainable development and social responsibility
(for further information see [13]). In order to include dividend payments to the anal-
ysis, total return indices are used, i.e., dividends are reinvested. This approach has
two main advantages. First, the index already represents a selected basket of the asset
category SRI and the time series are readily available. Second, the predefined index is
widespread and thus has the advantage that the companies’ specific risks are already
eliminated by diversification. As a result, only the diversification effect of the asset
class SRI itself is observed.
1.4.1. Description of the Dataset and Statistical Properties

The portfolio analysis is based on daily log-returns of the asset classes bonds (repre-
sented by the JP Morgan Global Government Bond Index), stocks (represented by the
Dow Jones Total Markets World Index), and SRI (represented, as described above, by
the ASPI index) between 1 January 1992 and 30 September 2008. The main empirical
statistics are shown in Table 1.4.
Table 1.4 Empirical Statistics of Daily Log-Returns.
Empirical statistics Bonds Stocks SRI
Mean 0.00024 0.00026 0.00038

Mean (annualized) 0.05917 0.06399 0.09425
Standard deviation 0.00389 0.00803 0.01216
Standard deviation (annualized) 0.06151 0.12702 0.19230
Skewness −0.00619 −0.29037 −0.13149
Excess kurtosis 1.44597 4.11292 3.58599
Autocorrelation: lag 1 0.03266 0.16873 0.00494
Autocorrelation: lag 2 0.00386 −0.02818 −0.02391
Autocorrelation: lag 3 −0.01373 −0.02108 −0.06324
Autocorrelation of squared returns (lag 1) 0.03859 0.13695 0.19301
5% critical value for autocorrelation 0.03026 0.03026 0.03026
By comparing mean and standard deviation of bonds and stocks, it becomes evi-
dent that most of the risk–averse investors would invest the bulk of their wealth in
bonds. This is due to the extremely high mean for bonds (5.92% per annum) combined
with a low standard deviation. Additionally, bonds display the highest skewness and
lowest excess kurtosis, which is generally preferred by risk–averse investors. As it is
a debatable point whether past returns indicate the future in a sufficient way, experts’
forecasts about expected returns are often used to solve this shortcoming. By using the
Black–Litterman approach to adjust the empirical returns, the empirical mean µemp
itself as well as absolute and relative forecasts are taken into account (see, e.g., [14]).
This approach can be interpreted as a linear combination of these two components at
a given confidence level τ regarding the forecasts. The Black–Litterman expectations
µBL can be expressed by (given that L is invertible)
µBL = τ · L−1 q + (1 − τ) · µemp , (1.1)
where L represents the linear transformation Lµ of the asset classes expected return
vector µ and for each forecast, whose actual value is specified in q. The assumptions
about the forecasts are taken from [15]. This means that the annual return of bonds is
expected to be 3.96% and the equity risk premium amounts to 3.5%. The additional
assumption that the difference of the means of stocks and SRI does not change leads to
   
1 0 0 0.0396/250
L =  −1 1 0  and q =  0.0350/250  .
0 −1 1 0.0303/250
For τ = 0, the Black–Litterman expectations are equal to the empirical means,
while τ = 1 leads to expectations which are completely driven by the forecasts.
Table 1.5 provides the Black–Litterman expectations for a confidence level of τ = 0.75.
10 Hroß et al.
Table 1.5 Black–Litterman Expectations for Asset Class

Log-Returns.
Black–Litterman expectations Bonds Stocks SRI
Daily return 0.00018 0.00029 0.00041

Annual return 0.04449 0.07195 0.10221
Table 1.6 P-Values of Jarque–Bera and Ljung–Box-Q Tests.
Test Null hypothesis Bonds Stocks SRI
Jarque–Bera Normal distribution <0.001 <0.001 <0.001

Ljung–Box-Q (Q1) No autocorrelation (up to lag 1) 0.0308 0 0.7438
Ljung–Box-Q (QS1) No ac. (squared returns, lag 1) 0.0096 0 0
The empirical returns are adjusted for the Black–Litterman expectations by apply-
ing a linear shift to the whole dataset. Hence, all other empirical statistics (except for
the autocorrelation in squared returns) are unaffected.
Skewness and excess kurtosis in Table 1.4 lead to the presumption that the returns
of all three asset classes are non-normally distributed. To test for non-normality and
autocorrelation, a Jarque–Bera test and a Ljung–Box-Q test (see [16] and [17]) were
applied. The p-values of both tests are given in Table 1.6. Italicised values are those
smaller than 0.05, for which the null hypothesis can be rejected at a significance level
of 5%.
As correlations are essential for diversification in a portfolio context, the corre-
lations of the empirical daily log-returns are listed in Table 1.7. The high correlation
between stocks and SRI is in line with the findings of [12]. One reason for this fact
may be that SRI stocks are simply a subset of the whole stock universe. Nevertheless,
each correlation coefficient smaller than one allows to benefit from diversification.
Table 1.7 Empirical Correlations of Daily

Log-Returns.
Correlation Bonds Stocks SRI
Bonds 1 −0.034524 0.044066

Stocks −0.034524 1 0.732227
SRI 0.044066 0.732227 1
1.4.2. Markov-Switching Model

Due to the described non-normality and autocorrelation of the considered time series
of daily log-returns, the standard Black–Scholes model, which implies i.i.d. normally
distributed log-returns, is not appropriate to describe the asset returns. As Markov-
Switching models allow for non-normality and autocorrelation at the same time, this
model class is applied in this study. To be more precise, a state-independent (first
lag) autoregressive Markov-Switching model as introduced in [18] is utilized. Further
applications of Markov-Switching models in a portfolio context can, e.g., be found
in [15] or [19].
It is assumed throughout that the return of asset class a ∈ {1, 2, 3} at time t is
given by
rt,a = µst ,a + φa · (rt−1,a − µst−1 ,a ) + t,a , (1.2)
where st indicates the state of the markets at time t, µst ,a denotes the mean return of
the asset class a in state st . Here, a = 1 corresponds to the asset class bonds, a = 2 to
stocks, and a = 3 to the SRI asset class. Furthermore, t = (t,1 , t,2 , t,3 )T represents
the innovation at time t with t ∼ N(0, st ) and φa the autocorrelation parameter for
asset class a satisfying |φa |<1.
The Markov-Switching model allows the market to be in two different regimes
(st = 1 for state 1 and st = 2 for state 2). For the reasons adduced in [15], only two
meta states are allowed. As a result, all three assets are in the same state at each point
of time t. Changes between the two states over time are modeled by a Markov chain
with transition probabilities given by the matrix

p11 p12
P= ,
p21 p22
where P(st = j|st−1 = i) = pij .
Therefore, the whole process is parametrized by a vector
θ = (µ1 , µ2 , p12 , p21 , φ, 1 , 2 )
with µ1 , µ2 ∈ R3 , φ ∈ [−1, 1]3 , p12 , p21 ∈ [0, 1], and 1 , 2 ∈ R3×3 . The assumption
of only two meta states has the great advantage that overfitting problems can be avoided.
1.4.3. Fitting the Model Parameters

The model parameters are fitted in a way that the empirical moments equal the moments
of the Markov-Switching process best possible. The applied method of moments is
described in detail in [18]. With regard to the empirical statistics, the focus of the
fitting lies on the first four moments and the autocorrelation of lag 1. The resulting
parameters and transition probabilities are displayed in Table 1.8.
12 Hroß et al.
Table 1.8 Markov-Switching Model Parameters.
Parameter µ1 µ2 σ1 σ2 φ p12 p21
Bonds 0.00018 0.00015 0.00325 0.00630 0.03270

Stocks 0.00062 −0.00108 0.00519 0.01473 0.16550 0.0579 0.2425
SRI 0.00064 −0.00055 0.00812 0.02166 0.00389
The parameters allow for the derivation of crucial information about the two
possible meta states. State 1 characterizes a bull market for all three assets. The expected
return of stocks and SRI is almost the same (15.4% p.a. for stocks and 16% p.a. for
SRI) whereas the standard deviation is much higher for SRI. In state 2, the expected
return of bonds only suffers a small decline compared to state 1 (from 4.6% p.a. to
3.8% p.a.) but the volatility nearly doubles in this regime. For stocks and SRI state 2
resembles a bearish market with huge losses for both asset classes (−26.9% p.a. for
stocks and −13.9% p.a. for SRI) and high standard deviations. The observation of an
increasing volatility in falling markets can be found in empirical studies like [20]. The
transition probabilities p12 and p21 of the Markov chain imply a realistic stability of
the two possible states. If the market is in a bullish or a bearish scenario respectively,
the market remains in the current state on the following day with a high probability.
As the fitting is based on minimizing the sum of squared deviations between the
empirical and theoretical statistics, these are outlined in Table 1.9.
The close match is emphasized by the theoretical correlations of the model, which
fit the empirical correlations very well (compare Tables 1.7 and 1.10).
It is worthwhile to have a look at the correlation structures of the error terms t ,
which are depicted in Table 1.11. The correlation of the error terms between stocks and
SRI is about 0.9 in the “bad” state (state 2) and thus much higher than in the “good”
state (state 1) with about 0.47.
Table 1.9 Empirical and Theoretical Statistics of Daily Log-Returns.
Statistics Mean Std. dev. Skewness Ex. kurt. Autocorr.
Bonds Empirical 0.0001780 0.003890 −0.006192 1.445971 0.032663

Theoretical 0.0001777 0.004020 −0.006200 1.517654 0.032703
Stocks Empirical 0.0002878 0.008033 −0.290370 4.112919 0.168726
Theoretical 0.0002890 0.008109 −0.287749 4.122927 0.169116
SRI Empirical 0.0004088 0.012162 −0.131494 3.585990 0.004943
Theoretical 0.0004100 0.011994 −0.130343 3.680593 0.004961
Table 1.10 Theoretical Correlations of Daily Log-Returns.
Bonds 1 −0.033037 0.043037

Stocks −0.033037 1 0.733543
SRI 0.043037 0.733543 1
Table 1.11 Correlation Structure of Error Terms in States 1 and 2.

State 1
Bonds 1 −0.264006 −0.414615

Stocks −0.264006 1 0.467326
SRI −0.414615 0.467326 1
State 2
Bonds 1 0.140301 0.414109

Stocks 0.140301 1 0.896169
SRI 0.414109 0.896169 1
1.4.4. Simulation of Returns

The portfolio optimization case study will be based on the distribution of simulated
returns according to the model in Sec. 1.4.2. Therefore, a Monte Carlo simulation with
20,000 return paths is conducted. Each path consists of 1250 returns and represents,
assuming 250 trading days per year, five years of data for each asset class. The initial
state of the underlying Markov chain is drawn from the stationary distribution π =
(π1 , 1 − π1 ) with π1 = p21 /(p12 + p21 ).
Due to non-normality and the importance of skewness and kurtosis with respect to
the risk aversion of an investor (risk–averse investors have a positive preference direc-
tion for skewness and a negative one for excess kurtosis), it is necessary to introduce
more complex portfolio concepts compared to a pure mean–variance optimization.
1.4.5. Portfolio Optimization Models

Having deduced the distributions of the simulated return paths, five different models are
applied in order to optimize the investor’s portfolio. Two constraints for the portfolio

weights x ensure a full investment of the available budget ( 3i=1 xi = 1), and avoid
short-selling (xi ≥ 0, i = 1, 2, 3).
14 Hroß et al.
0.11
Bonds
0.10 Stocks
SRI
0.09 Bonds, stocks
Expected return
Bonds, stocks, SRI

0.08
0.07
0.06
0.05
0.04
0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20
Standard deviation
Figure 1.1 Efficient frontier for one-year time horizon.
The traditional mean–variance framework based on [21] only takes the first two
moments of the return distribution into account. It is defined by
λ T
x x, max xT µ − (1.3)
2 x
where µ denotes the vector of expected asset returns, the return covariance–matrix,
and λ the risk–aversion parameter of the investor.
Figure 1.1 shows the diversification effect which can be obtained by including the
asset SRI into an existing portfolio of bonds and stocks.
Due to the importance of higher moments within the portfolio context, the power-
utility model and frameworks which maximize different performance measures are
introduced in the following.
The power-utility model is defined by the optimization problem

 max E[γ −1 (1 + R(x))γ ], γ < 1 ∧ γ = 0
max E[U(R(x))] = x
, (1.4)
x  max E[ln(1 + R(x))], γ=0
x
where γ describes the risk aversion of the investor and R(x) is the portfolio return
depending on the portfolio weights x.
The third optimization model maximizes the performance measure
introduced
in [22]. In this framework, each investor can set a threshold to classify the returns
into gains (returns above the threshold) and losses (returns below the threshold).
is
defined as the ratio of probability-weighted gains to losses and thus equal to the upside
potential divided by the downside potential. The corresponding optimization problem
is given by
E[R(x) − τ]+
max
τ (R(x)) = max , (1.5)
x x E[τ − R(x)]−
where τ is the loss threshold and R(x) the portfolio return for portfolio weights x.
The performance measure Score-value considers the difference of upside and
downside potential. The risk-free rate r is used as threshold and the downside potential
is weighted with a risk–aversion parameter λSc . This leads to an optimization problem
defined by
max ScoreλSc (R(x)) = max E[R(x) − r]+ − λSc · E[r − R(x)]− . (1.6)
x x
The Mean-Conditional Value at Risk (MCVaR) is a risk measure referring to the tail
of a distribution. It is based on the Conditional Value at Risk (CVaR) defined by
CVaR(R(x)) = E[R(x)|R(x) < VaR(R(x))], (1.7)
where VaR(R(x)) is the Value at Risk (see, e.g., [23]) of the portfolio return R(x) at
a given confidence level α (in the case under consideration α = 99.5%). In order to
consider both risk and return, the optimization problem is given by
max MCVaRλMCVaR (R(x)) = max E[R(x)] − λMCVaR CVaR(R(x)) (1.8)
x x
with λMCVaR denoting the respective risk–aversion parameter.
1.4.6. Definition of Investor Types

All optimization models introduced above take different levels of risk–aversion into
account. To consistently define investor types over the different models, the risk–
aversion parameters are chosen such that they result in the same optimal asset allo-
cations in a world where only stocks and bonds exist (see, e.g., [19]). In this case
study, three investor types with different levels of risk aversion are used. They are
represented by their characteristic benchmark portfolios with bonds:stocks equal to
0.7:0.3 (Investor A), 0.5:0.5 (Investor B), and 0.3:0.7 (Investor C). For the one-year
time horizon, the respective parameters are given in Table 1.12.
1.4.7. Optimal Portfolios

Using the risk–aversion parameters of the three different investor types, optimal port-
folios of bonds, stocks, and SRI are constructed. The optimization is conducted for all
introduced frameworks with time horizons of one, three, and five years. As the results
are quite similar for all three time horizons, only the results of the one-year horizon
16 Hroß et al.
Table 1.12 Risk–Aversion Parameters for the Three Investor

Types (One Year).
Risk aversion λ γ τ λSc λMCVaR
Investor A 7.0609 −6.9009 0.0245 3.0632 0.1957

Investor B 2.8570 −2.8353 0.0390 1.8072 0.0983
Investor C 1.7908 −1.7820 0.0427 1.6328 0.0768
Table 1.13 Weights and Performance Measures of Optimal Portfolios (One Year).
Framework MV PU Omega Score MCVaR
Portfolio weights
Bonds 0.6735 0.6732 0.6605 0.6252 0.6169

A Stocks 0.0759 0.0722 0.0624 0.0360 0.0376
SRI 0.2506 0.2546 0.2771 0.3388 0.3455
Bonds 0.3968 0.3955 0.3832 0.0000 0.0000
B Stocks 0.0000 0.0000 0.0000 0.0000 0.0000
SRI 0.6032 0.6045 0.6168 1.0000 1.0000
Bonds 0.0940 0.0927 0.1114 0.0000 0.0000
C Stocks 0.0000 0.0000 0.0000 0.0000 0.0000
SRI 0.9060 0.9073 0.8886 1.0000 1.0000
Risk and performance measures
Sharpe 0.3542 0.3547 0.3586 0.3663 0.3671

Omega 3.5017 3.5026 3.5055 3.4881 3.4828
A
Score −0.0112 −0.0112 −0.0110 −0.0107 −0.0107
MCVaR 0.0329 0.0330 0.0331 0.0333 0.0333
Sharpe 0.3693 0.3693 0.3687 0.3497 0.3497
Omega 2.3309 2.3309 2.3310 2.2879 2.2879
B
Score 0.0208 0.0209 0.0211 0.0285 0.0285
MCVaR 0.0545 0.0545 0.0547 0.0605 0.0605
Sharpe 0.3540 0.3540 0.3549 0.3497 0.3497
Omega 2.1796 2.1796 2.1796 2.1779 2.1779
C
Score 0.0342 0.0342 0.0337 0.0366 0.0366
MCVaR 0.0673 0.0673 0.0669 0.0695 0.0695
are presented in detail here. Table 1.13 shows the optimal portfolio weights as well
as the computed performance measures
, Score-value, MCVaR, and Sharpe ratio.
The first three were already introduced in Sec. 1.4.5. The well-known Sharpe ratio
measures the expected excess return over the riskless investment in units of standard
deviation (see [24]). The low risk–averse Investor C invests largely into SRI. In the
mean-variance (MV), the power-utility (PU), and the Omega framework, he allocates
around 90% into SRI and in the Score-value and the MCVaR framework he is com-
pletely invested in SRI. As Investor C does not invest in stocks at all, the remainder
of his wealth is invested in bonds. The strategy of Investor B is very similar with the
only difference being that the portfolio weights of the asset class SRI are smaller in the
MV, PU, and Omega framework. The best diversified portfolios are held by the highly
risk–averse Investor A. Most of his wealth — between 61% and 68% — is invested
into bonds. The majority of the remainder is allocated to SRI, leading to a fraction of
25–35% and only a small amount is invested into stocks (between 3–8%). Overall, the
results emphasize that SRI can be interpreted as a substitute for stocks and that only
the most risk–averse investor allocates money to the substituted asset class in order to
benefit from the diversification effect.
Figures 1.2 (a)–(e) illustrate the portfolio allocations in dependence of the respec-
tive risk–aversion parameter. The vertical lines indicate the three considered investor
types. The solid line displays the risk of the portfolios measured by the standard
deviation of the portfolios’ returns. As mentioned above, the proportion invested into
stocks is due to the substitution effect always very small or even zero. A further inter-
esting issue is the development of the proportion invested into bonds. In the MV,
PU, and Omega framework, the fraction of bonds increases slowly with increasing
risk–aversion whereas it ascends late but steeply in the Score-value and the MCVaR
framework what results in an enormous reduction of risk from that point on.
In order to get more information about the substitution effect, a sensitivity analysis
is performed for the mean–variance framework with a one-year time horizon. As only
the most risk–averse investor allocates parts of his wealth to stocks, the question
arises under which circumstances the less risk–averse Investor C mixes stocks into
his portfolio. For this purpose, the Black–Litterman expectation for the annual return
of SRI is gradually decreased, starting from a value of 10.22% (see Table 1.5). With
the help of the overall probability π1 (see Sec. 1.4.4) the amount of reduction can
be split up for the two regimes. For state 1 the reduction is π1 · and for state 2 it
equals (1 − π1 ) · . While facing the same risk exposure, the upper hurdle rate for the
expected return is determined by a value of 9.27%. This value represents the highest
expected return of SRI for which Investor C still invests a small amount into stocks.
A further decrease of the expected return leads to a partial replacement of SRI by
stocks. The lower hurdle rate is given by an annual SRI return of 7.01%, i.e., if the
expected return is below the lower hurdle rate Investor C will not invest in SRI anymore
and therefore create the appropriate benchmark portfolio of 70% stocks and 30%
bonds.
18 Hroß et al.
Figure 1.2 Optimal portfolio weights in different optimization frameworks.
1.5. CONCLUSION
SRI is a growing asset class. By analyzing SAM sustainability scores, it was shown
that an SRI portfolio has a high degree of consistency, i.e., sustainable companies are
likely to stay sustainable in the future. For the best ranked companies, the probability
of being in the 1st quartile again in the next year is 70% on average. Moreover, optimal
portfolios for different investor types are constructed. The parameter estimates of the
underlying Markov-Switching model are based on a time series ranging from 1992
to 2008. The main finding of the conducted case study is that SRI turns out to be a
substitute for stocks and that the less risk–averse an investor is the more he invests in
SRI, respectively, does a full investment into this asset class. More risk–averse investors
use all three asset classes in order to gain from diversification effects. Nevertheless,
only a very small fraction (<8%) is invested into stocks.
References
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LISTED PRIVATE EQUITY

IN A PORTFOLIO CONTEXT
2
PHILIPP AIGNER∗ , GEORG BEYSCHLAG† ,
TIM FRIEDERICH‡ , MARKUS KALEPKY§
and RUDI ZAGST¶
∗
Max-Planck-Str. 1, 81675 München, Germany
philipp.aigner@gmx.de
†
Brixener Str. 17, 86720 Nördlingen, Germany
georgbeyschlag@yahoo.de
‡
risklab GmbH, Seidlstraße 24-24a, 80335 München, Germany
tim.friederich@risklab.com
§
Ringgasse 24, 55218 Ingelheim, Germany
markuskalepky@gmx.de
¶
HVB-Stiftungsinstitut für Finanzmathematik, Technische Universität München,
Boltzmannstr. 3, 85747 München, Germany
zagst@tum.de
This chapter first provides a comprehensive overview of private equity by categoriz-

ing the private equity investments into financing stages, divestment strategies, and
types of financing. Different ways of investing in the asset class “private equity” are
characterized, ranging from direct investments, which are hard to access, to listed pri-
vate equity (LPE) investments, which provide a liquid means for investors to consider
private equity in their portfolios. A Markov–Switching model is presented, which is
able to capture the characteristics of the asset class LPE. By applying several risk
measures and optimization frameworks, the question of the optimal fraction for an
LPE investment in an investor’s portfolio is scrutinized. Depending on the risk aver-
sion of the investor, the optimal fraction of an LPE investment in this study ranges
between 0% for a very risk–averse investor, 7.5–11.8% for a moderately risky investor,
and 16.9–27.9% for an investor willing to take higher risks.
21
22 Aigner et al.
2.1. INTRODUCTION
Private equity investments have probably been ventured since men try to augment
their personal wealth. The voyage of Christopher Columbus, who received funding
from various noblemen for his supposed expedition to Asia, is often referred to as a
well-known example of the historical roots of this asset class. By the middle of the
last century, individual financiers, affectionately dubbed business angels, crossed the
threshold to the present-day notion of private equity investment: They granted money
along with management support to high-tech start-up companies and actively sup-
ported young entrepreneurs in order to maximize the value of their own investment. In
the 1970s, investment constraints previously imposed on institutional investors were
relaxed by providing for vast additional capital channels. Thus, the venture capital
market appeared significantly altered by the late 1980s: Not only high-tech start-up
companies engrossed the investors’ attention, yet more established enterprises and
firms not having technology-related products in their portfolio came into financial
support as well, and debt financing grew more and more important. A profuse array
of various funding practices such as restructuring, buyout, or mezzanine emerged.
Together with the traditional venture capital, they evolved to an asset class known
as private equity, which enjoyed enormous growth and returns over the last five
years.
With the credit crisis followed by an overall economic downturn becoming the
prominent topic in 2008, one may raise the question whether private equity is still an
asset class worthwhile considering. And indeed, both columnists and scientists forecast
great changes which the industry is about to experience: Since the credit markets have
basically come to halt, procuring debt for leveraged buyout transactions was virtually
impossible, resulting deal volumes to plummet by 75% in 2008. Default probabilities
for portfolio companies may be as high as 50% and consequently, most institutional
investors have been reducing the exposure to private equity, see [16].
However, private equity still displays characteristics, which make it an interesting
part of a well-diversified investment strategy: Since private equity tends to display
only a moderate correlation to the public equity market, it may extend the portfolio’s
efficient frontier, and thus, yield a better risk–return profile. Furthermore, the persis-
tence in performance of top-quartile private equity firms has also proven valid in past
crises and is likely to do so in the future, see [1, 5, 21]. Private equity funds might
even play a key role in the economic recovery process. Currently, the private equity
industry holds $450 billion waiting to be invested [16]; thus, besides governments
and sovereign wealth funds, they are the only source for liquidity to an ailing econ-
omy. Since private equity funds tend to generate even greater returns when acquiring
portfolio companies during grave economic periods, now might be the right timing to
increase one’s exposure to private equity vehicles, see [1].
Listed Private Equity in a Portfolio Context 23
The remainder of this article is structured as follows: First the basic ideas and
different categories concerning private equity are delineated, then various investment
vehicles are expounded, and finally means of determining the optimal fraction of listed
private equity entities in a portfolio are developed.
2.2. DEFINING PRIVATE EQUITY CATEGORIES
Delineating the notion of “private equity” is certainly not facile. In general, private
equity is a broad term that refers to any type of equity investment in an asset in
which the equity is not freely tradable on a public stock market. Furthermore, a private
equity investment usually entails a rather long engagement period, although it is always
temporary with an exit strategy sometimes already existing at the time of the investment
being ventured. Before one can probe into the various classes of private equity (see
Sec. 2.3) it is pertinent to scrutinize the criteria which distinguish them.
2.2.1. Financing Stages

Private equity investments can be conducted in various stages of a company’s financial
life-cycle. Roughly speaking, it is differentiated between an early stage, an expansion
stage, and a late stage.
Early Stage Financing. Early stage financing comprises seed financing, start-up
financing, and first stage financing. During the seed phase solely a conception of the
business and the product exist, with the founder himself or some acquaintances of
his raising the money required. The start-up period is dedicated to the composition
of a business plan while the financial burden is still primarily imposed on the previ-
ously mentioned persons. With the first stage commencing, the entrepreneur launches
production and selling of his product. These first revenues, however, are easily out-
numbered by the increasing expenditures.
Expansion Stage Financing. During the expansion stage, the business strives for
continuous growth and attempts to break even; then, an expansion to new markets
and a diversification of the array of products is aimed at, and the sales and distribution
process is adapted to this development. Compared with the early stage, the risk involved
is lowered significantly.
Late Stage Financing. With the late stage commencing, the business is usually fairly
well established. According to its situation and its prospects, there are various possi-
bilities to be proceeded with. One might be the alignment of the enterprise to a future
24 Aigner et al.
IPO, i.e., initial public offering of its share at a stock market; doing this, bridge financ-
ing provides for an ameliorated equity ratio. A financing aimed at changing the capital
structure of the portfolio company is also called “recapitalization” or “consolidation.”
Another possible strategy might be a separation of the firm from its former owners.
This can be achieved by a management-buyout (MBO) with the former executives
becoming the new shareholders or by a management-buyin (MBI), where previously
unengaged investors assume both stakes and operational control. With the new owner
usually not being able to raise the money required for the purchase on their own,
buyout financing, which can be composed of equity, debt, and mezzanine products,
is required. If the debt ratio of the deal exceeds 50%, the expression of a leveraged
buyout applies, see [13].
Turnaround financing comes in handy if the enterprise struggles and feels inclined
toward augmenting the equity ratio to become attractive to debt capital providers again.
Funds specializing in this practice usually offer also consultant services to increase
the odds of a successful turnaround. This type of investment strategy is sometimes
referred to as “distressed financing.”
2.2.2. Divestment Strategies

Initial Public Offering (IPO). An IPO is probably the most remunerative exit strat-
egy for a private equity investor, as the sale price achieved is usually quite notable due
to a high degree of transparency and decent market liquidity. Furthermore, it provides
for a good publicity to both the private equity fund and the portfolio company, which
facilitates the alignment of interests. However, the downside of this exit strategy is the
great dependence on a favorable stock market environment and significant costs due
to regulatory and legal constraints.
Trade Sale. Selling the investment to another corporation is called “trade sale.” As
the purchaser predominately operates in the same industry like the portfolio company,
he may benefit from strategic advantages when incorporating the venture to be sold into
his corporate structure and thus pays even a higher price than an IPO might generate.
Additionally, transaction fees are usually lower than in an IPO sale. Although the
portfolio company mostly thrives upon such an arrangement, its management might
be hesitant, as their own position and independence could be affected.
Secondary Sale/Financial Sale. An exit is called “secondary sale,” if the purchaser

is also a financial investor; thus, a synonym for this way of exit is “financial sale.” This
type of divestment is usually chosen if the seller has undergone a change of investment
strategy or requires capital, which cannot be procured anywhere else. Consequently,
due to lofty yield expectations of the purchaser, the capital gains obtainable with a
secondary sale are rather limited while transaction costs tend to be fairly moderate.
Buy-Back. “Buy-back” refers to a divestment approach, where the target company,

especially its management, acquires the shares to be sold by the private equity investor.
This strategy is apt for rather less successful companies, which cannot be hived off
by a trade sale or IPO, whereas some family-controlled businesses actually insist on
a contractual agreement on buy-back conditions prior to letting a private equity fund
invest in their business.
Total Loss/Liquidation/Distressed. Liquidation of a business is undoubtedly the

least pleasant way of disinvestment. It is only adopted if the company is “dead more
worth than alive” and will certainly experience grave resistance by the portfolio com-
pany’s management and staff. In case of a liquidation, the provider of debt (i.e., the
creditor) holds claims, which are senior to those of equity investors; with liabilities
usually exceeding the assets of a distressed company, its liquidation mostly results
in a total loss of money for the private equity investor. Sometimes, exiting a firm
that is financially troubled or even already insolvent is categorized as “distressed.” In
that case, private equity companies specialized in turnaround-financing might pose a
follow-on investor, see [15].
2.2.3. Type of Financing

The type of capital used for a private equity investment also accounts for its classifi-
cation. The basic categories are equity, debt, and mezzanine.
Equity Financing. Equity is, as the expression “private equity” suggests, the most
common capital source of the private equity industry. An equity investor enjoys a
proportional claim to a company’s assets, which usually depends on his share of the
company’s book value. He is mostly entitled to vote at the shareholders’ meeting and
thus, wields influence on the company’s business strategy and its management. In
case of an insolvency, equity is characterized by its junior treatment in the liquidation
process. Equity investors only recover the invested capital after all claims resulting
from debt financing are satisfied. Therefore, they face the peril of not only losing the
invested principal, yet also might be obliged to inject fresh capital into the firm, if it has
a corporate structure rendering the stakeholder personally liable, see [4]. Evidently an
equity investment is deemed to be riskier (than debt financing), and thus the expected
return is higher due to the risk premium, which an equity investor expects. Owing
to these characteristics, equity is the preferred type of financing for rather young
companies, as it does not require a collateral which these companies mostly could not
26 Aigner et al.
provide for. Equity is provided to the portfolio company either by purchasing shares
from the previous stakeholder, or raising “fresh” equity capital by the private equity
investor, or granting equity capital in the form of a dormant partnership.
Debt Financing. Opposed to equity, debt is provided to a company only for a pre-
determined and limited time. The debt investor’s claim is senior to claims of equity
providers in case of an insolvency. Therefore, he is not liable, and he only risks the
loss of the committed principal in case of a default. The debt investor’s return, i.e.,
the interest payments, are due at predefined, fixed dates regardless of the portfolio
company’s performance, which accounts for the name “fixed income investment.” As
the cash flows — apart from default situations — are predictable, the risk and, conse-
quently, also the return associated with debt financing is lower than in the equity case.
Debt is predominately a prevalent means of financing late-stage portfolio companies.
Furthermore, debt does not affect the ownership situation, which is often desired by
family-owned portfolio companies, and might grant tax-related benefits to the invested
firms, as it can deduct the interest payments from the taxable revenues.
Mezzanine Financing. Mezzanine financing can be deemed a hybrid structure

between equity and debt financing. The first mezzanine financing is recorded to have
taken place in 1910, when the Computing-Tabulating-Recording Company (today:
IBM) issued high yield bonds for the purpose of start-up financing. Sometimes, mez-
zanine capital is furnished with an “equity-kicker”, which allows for a participation in
capital gains in the case of an IPO. Along with the typical interest payment associated
with debt, mezzanine capital will often include an equity stake in the form of warrants
attached to the debt obligation or a debt conversion feature identical to that of a convert-
ible bond. Mezzanine financing is junior to debt and senior to equity financing in case
of a default. It is only secured by the equity of the company, and not the company’s
tangible assets (e.g., property, cash, or accounts receivable). Therefore, mezzanine
capital is a more expensive financing source for a company than secured debt or senior
debt, as its risk of default is greater, which results in the investors demanding a higher
interest rate, usually 200–800 basis points above a “regular” loan, see [15].
2.2.4. Classification of Private Equity Fund Investments

According to these previously depicted criteria, private equity funds can generally
be grouped into two categories: (1) venture capital and (2) buyout funds.
2.2.4.1. Venture capital funds

Venture capital funds invest in new (i.e., early or expansion-stage) companies with
a promising idea, innovation, or product predominantly to be found in technology,
telecommunications, or healthcare sectors. They mostly provide equity financing, opt

for an IPO as preferred exit route, and therefore are strongly correlated with small
cap indices. Extensive market and product due diligence is the major focus during
the selection process. The fund has to handle the immeasurable uncertainty associated
with its investment and relies on its industry know-how, product development, and
commercialization expertise; therefore, providing consultancy services to the portfolio
company is crucial to succeed. The investor focuses on few “winners” and accepts many
write-offs, see [19].
2.2.4.2. Buyout funds

Buyout funds invest in established, i.e., late stage companies that need capital for
changing the ownership. Buyout funds are mainly debt financed and tend to per-
form well during bearish public equity market periods, when debt is available at low
costs. Intensive financial due diligence is the major focus during the selection process.
Putting emphasis on established industry sectors, the fund has to handle rather measur-
able risks and relies on its financial engineering and corporate restructuring expertise.
The investor focuses on a high percentage of successful investments with only lim-
ited number of write-offs. As previously depicted, “buyout fund” is a generic term
comprising management buyout (MBO), management buy-in (MBI), and leveraged
buyout (LBO) activities.
2.2.4.3. Leveraged buyouts (LBO)

As LBOs account for the bulk of private equity deals, it is pertinent to shed more light
on this type of buyout transaction. The purpose of financial leverage with regard to
investments is fairly straightforward: The private equity fund incurs debt, which is
reinvested in portfolio companies along with equity capital. If the overall investment’s
return is higher than the cost of interest, the private equity investor yields a greater
return on its equity stake than if it does not borrow. The idea of a leveraged buyout
hinges on the validity of the Modigliani–Miller Theorem, see [20]. It states that the
value of a firm is unaffected by how the firm is financed. It does not matter if the
firm’s capital is raised by issuing stock or selling debt. If this was not the case, there
would be an arbitrage possibility. Therefore, when a private equity fund conducts a
leveraged buyout, the value of the target company — as far as theory goes — ought
not to decrease. Hence, it is possible that a large portion of the purchase price is debt
financed — sometimes up to 95% of the target company’s total capitalization. Doing
this, private equity firms can conduct large acquisitions without having to commit a
lot of capital. Typically, the loan is borrowed through a combination of repayable bank
facilities and/or public or privately placed bonds, which may be classified as high-yield
debt, also called “junk bonds.” The debt will predominantly appear on the acquired
28 Aigner et al.
company’s balance sheet and the acquired company’s free cash flow will be used to
repay it, see [4].
Although the sources of value generation for buyout deals are manifold, they can
be basically cut down to the following three aspects:
Bondholders. Investors holding bonds of the target company are the obvious losers
of a leveraged buyout deal: As previously mentioned, the debt of a buyout is mostly
collateralized with the target company’s assets; therefore, the existing bond holders
would have to “share” the target company with the upcoming bondholders in case
of a default. Thus, bond prices tend to plummet, as soon as a leveraged buyout is
announced.
Tax shields. Debt financing displays the great advantage that the interest the company
pays to creditors is a tax-deductible expense, while dividends, the “cost” of equity
capital, are not. The amount of tax payments which the company can avoid by incurring
debt is called “tax-shield.” Provided that the value of a company is unaffected by the
way it is financed (Modigliani–Miller Theorem [20]), the present value of the tax-
shield equals the increase in value of a firm when a private equity fund raises the
amount of debt in its target’s capital structure.
Incentives. Greater incentives for the company’s management and its employees
can account for yet another source of value generation as people need to increase
their efforts to come up with the cash needed for debt service. Furthermore, senior
managers are usually obliged to place a considerable amount of their personal wealth
in the company they lead.
2.3. INVESTMENT POSSIBILITIES — ONE ASSET,

MANY CLASSES
When contemplating an investment in private equity, one should bear in mind that
there are manifold possibilities of obtaining exposure to this asset class each of which
are visualized in Fig. 2.1.
2.3.1. Direct Investments

The most genuine way of investing in private equity certainly is the direct pur-
chase of shares of a single company. As this requires superior skills pertaining to
the selection and the supervision of the acquired firm, the timing and execution of
the divestment, it usually takes a team of professionals to perform these duties and
meet these challenges adequately. With 30% of direct investments resulting in a total
Figure 2.1 Private equity investment possibilities.
loss, with target-companies usually stating a preference for an established private

equity investor, and with the fraction of private equity in a standard portfolio being
fairly low and consequently, the cost associated with a direct investment disproportion-
ately high, it is usually a prudent choice to opt for different fashions of private equity
investments.
2.3.2. Private Equity Funds

Instead of directly giving money to the target companies the investor can also pick an
investment fund as financial intermediary, which assumes all duties from the selection
process to the exit planning, see [13].
2.3.2.1. Key players

General Partner. The term “general partner” (GP) is equivalent to the expression
“fund manager” or better “fund management team” of a private equity fund, as it is
usually operated by more than one person. The general partner contributes about 1%
of the invested capital to his private equity fund.
Fund Management Company. The management company commonly supervises

various general partners. It receives an annual management fee of about 1.5–2.5% of
the committed capital.
Fund. The private equity fund is established by a limited partnership agreement

between the general partner and the limited partners. The general and the limited
partners arrange their commitment to the private equity fund with Participation
Agreement 1 (see Fig. 2.2).
30 Aigner et al.
Figure 2.2 Structure of a private equity fund.
Limited Partner. The limited partners provide for the bulk of the committed capital
(∼99%) and are accordingly called “investor” or “sponsor.” The investment activity
of large institutional investors carries today’s industry. Therefore, the main players in
the market are pension funds, insurers, funds-of-funds, banks, government agencies,
corporate investors, foundations, and family offices.
Target Companies. Target companies, also dubbed portfolio or investee companies,

are the entities into which a private equity fund directly invests. This investment is often
referred to as “deal.”
Investment Process. Prior to conducting an investment, the private equity fund’s

general partner imposes a rigorous scrutiny on the companies he is interested in. On
average, only 25% of the businesses requesting financing from a private equity fund
manage to pass this hurdle, see [15]. These enterprises are to experience an in-detail due
diligence. Usually, the due diligence process contains three components: The legal due
diligence appraises all important contracts and agreements, the financial due diligence
assesses the completeness and accuracy of financial statements, and the business due
diligence probes into the economic prospects of the enterprise. With the due diligence
being completed the parties may agree upon a letter of intent binding them to proceed
with the selection process. The transaction process concludes with the signing of the
Participation Agreement 2 (see Fig. 2.2) and the closing which comprises the transfer
of the target company’s stakes in return to payment of the purchase price.
Banks. Banks usually play an important role in leveraged buyout transactions as they
provide for the necessary amount of debt capital. The target company predominantly
serves as collateral for these loans (see Fig. 2.2).
2.3.3. Cash Flow Structure of a Private Equity Fund

Limited Partners’Contribution. The limited partners usually contribute about 99%
of a fund’s volume. It is pertinent to differ between the committed capital, which is
the maximum amount the limited partners may be obliged to deposit into the fund
and the drawdown. The latter denotes the money actually requested by the general
partner which he does whenever there is a worthwhile investment opportunity. On
the other hand, cash distributions to the limited partners are made as soon as a deal
is realized by the fund manager. From the standpoint of the limited partners, the
investment process entails substantial uncertainty: The timing of both drawdowns
and distribution is unpredictable and the valuation of the portfolio is sometimes not
meaningful, as regular marking to market of the investment is too costly and thus left
at the general partner’s discretion.
Management Fees. Management fees provide for a base compensation so the fund
manager can support ongoing activities of the fund. On the other hand, the management
team should not make any profits on those fees, as compensation reasonably ought
to be performance driven. Therefore, annual fees range between 1.5% and 2.5% of
the committed capital. Levying fees on a committed capital basis prevents the fund
managers from going “for volume instead of quality,” i.e., drawing down and investing
more capital than he can find remunerative investment opportunities, see [19].
Carried Interest. Carried interest is a bonus entitlement accruing to an investment

funds management company or individuals of the management team which — as
it is their main source of income — has to provide for a commensurable incentive
to strive for a considerable fund performance. It is usually as high as 20% of the
profits of a fund and becomes payable once the investors have achieved repayment
of their investment in the fund plus a defined hurdle rate, which ranges between 6%
and 12%. Carried interest is calculated either on a “fund-as-a-whole” basis, where
the overall performance of a fund has to be in excess of the hurdle rate or a “deal by
deal” approach with the proceeds of a single transaction necessitating to surpass the
hurdle rate.
Gross/Net Cash Flows. As illustrated in Fig. 2.3 one can differ between two types of
cash flows: (1) Deal cash flows occur between the private equity fund and its portfolio
companies; as carried interest and management fees are not yet deducted, they are
also referred to as “gross cash flows.” (2) Fund cash flows occur between the private
equity fund and the investor (limited partner). Carried interest and management fees
had already been deducted at that point; thus, they are also referred to as “net cash
flow” or net distributions.
32 Aigner et al.
Figure 2.3 Cash flow structure of a private equity fund.
2.3.4. Fund-of-Funds
2.3.4.1. Structure of a private equity fund-of-funds
However, the process of selecting a successful fund is not trivial either, as choosing
an apt general partner is crucial to the fund performance which differs immensely.
Therefore, the investor may want to outsource this activity to a professional, together
with all the other chores entailed by being a limited partner. Hence, a fund-of-funds can
be deemed a vehicle that pools a group of investors and uses the capital to assemble a
diversified portfolio of funds. The organization of funds-of-funds basically resembles
the structure of regular private equity funds (see Fig. 2.4).
2.3.4.2. Advantages
Diversification. The possibility of greater diversification is definitely one of the
greatest advantages of funds-of-funds, as various studies have shown that they perform
similarly to individual funds but with less pronounced extremes. With funds-of-funds
participating in up to 100 individual private equity funds averaging about 20 portfolio
companies, the investor can engage in about 2000 target enterprises. Furthermore, very
specific expertise is required when investing in new industries, emerging regions, or
financing stages. As an individual fund cannot specialize in every field, it is certainly
pertinent to get exposure to different private equity markets via a fund-of-funds.
Resources. Usually both institutional investors and individuals lack the expertise of
research, due diligence, ongoing monitoring, reporting, and administration of a private
equity fund investment.
Figure 2.4 Structure of a private equity fund-of-funds.
Liquidity Management. The vast majority of private equity funds do not know
either the timing or the size of the distribution cash flows. However, they do follow the
pattern with cash out-flows during the first half and in-flows during the second half of
a fund’s lifespan. With a fund-of-funds having many individual funds in its portfolio,
the aggregate cash flows become more predictable and thus they can agree upon pre-
defined payout schedules, which especially favor the needs of retail customers.
2.3.4.3. Disadvantages
The greatest drawback associated with a fund-of-funds is the additional layer of fees
the investor is charged. Funds-of-funds charge a management fee customarily ranging
between 1.0% and 1.5% of the committed assets and additionally receive carried
interest once the hurdle rate is attained. However, funds-of-funds predominantly deduct
only 5% of the gains. Furthermore, investors typically have fewer possibilities of
wielding influence on the development of their money compared to a single-fund
investment. Beyond, funds-of-funds do not offer a tailor-made investment focus which
some investors may need in order to offset their underexposure to some countries or
industries.
2.3.5. Publicly Traded Private Equity

Investing in publicly traded private equity (PTPE), also called “listed private equity”
(LPE) if the entity is quoted at a stock exchange, is another approach to get exposure
34 Aigner et al.
to this asset class while maintaining a decent level of liquidity. As private equity
companies primarily hold the corporate structure of a limited liability partnership,
they are not publicly quoted. However, there are some previously or currently listed
companies whose core business is private equity. Furthermore, investment funds which
invest a predetermined share in private equity, and specially structured investment
vehicles which invest in private equity directly are to be found. Of course, one may
also purchase bonds issued by private equity companies or resort to a warrant with a
private equity company’s share as underlying value. Moreover, there are certificates
with a private equity index or a specific basket comprising private equity portfolios
with different investment focuses as underlying values.
LPX GmbH is a company based in Switzerland that specializes in constructing
indices based on listed private equity (LPE). It provides the global LPE index LPX50,
LPX Major Market, and LPX Composite; LPX GmbH also calculates and publishes
[17] regional indices such as the LPX Europe as well as style indices such as the LPX
Buyout, LPX Indirect, and the LPXVenture. For the portfolio calculations subsequently
conducted the LPX 50 is considered. The LPX 50 is a global index that consists of the
50 largest liquid LPE companies covered by LPX. The total return index (as opposed
to a price index) is applied here, which means that dividend payments are also included
by reinvesting them in stocks.
2.3.6. Secondary Transactions

Secondary transactions deal with securities, which are bought and sold after their
initial sale, while investors in the primary market purchase their investment instruments
directly from the issuer, see [11].
2.3.6.1. Types of secondary transactions

It is possible to differentiate between the following types of secondary transactions,
see [7]:
Limited Partner (LP) Secondary Transactions. This most commonly conducted

category of secondary transactions occurs, when the limited partner wants to withdraw
his investment from a private equity fund prior to maturity.
Portfolio Transfer. “Portfolio transfer” refers to a transaction of a fund’s aggregate

portfolio to another company. This type of sale is quite complex and entailed by an
in-depth due diligence of all the assets to be relocated.
Secondary Buyout. Purchase of selected portfolio companies by a general partner

is called “secondary buyout.” Compared to a portfolio transfer, a secondary buyout
appears to be less risky, as the purchaser can pick supposedly valuable targets.
2.3.6.2. Buyer’s motivation

There are various reasons why investors choose to sell their private equity stakes.
They may have overcommitted capital or overestimated timing and amount of cash
distributions and thus need liquidity. There might have been a change in strategy or
new regulatory provisions, which induce a fund to decrease exposure to some sectors,
countries, or asset classes. Depending on the intensity of pressure to divest the seller
faces, there is a good possibility for the buyer to receive a discount. Buying secondary
investments gives an opportunity of diversifying of vintage years, which is — due
to the great variability of performance depending on the vintage year — a possible
diversification approach. Furthermore, secondary investments have proven to display
anti-cyclic behavior: Due to higher discounts achieved during underperforming peri-
ods of the primary market, secondary transactions do specifically well in such times,
enabling a possible reduction of risk when incorporated into a portfolio. Addition-
ally, compared to the fund’s original investors, a secondary buyer gets his investment
back faster, as there is only a limited amount of original investment opportunities in
the market, it usually takes several years for the complete committed capital to be
invested, whereas the secondary investor invests his commitment all at once. There-
fore, a secondary transaction is a reasonable means of quickly attaining private equity
exposure.
2.4. PRIVATE EQUITY AS ALTERNATIVE ASSET CLASS

IN AN INVESTMENT PORTFOLIO
After a detailed description of the different types of private equity investments, the
benefits of private equity for asset allocation purposes are analyzed in the following.
Like every other alternative asset class, private equity is supposed to provide diversifi-
cation benefits, i.e., reducing the risk of a portfolio while keeping the expected return
at a high level, or, respectively, increasing the expected return while not bearing a
higher risk. Unfortunately, it is not easy to measure the performance of private equity
investments. This is due to the fact that — except for listed private equity vehicles —
there is usually only a very limited secondary market. Hence, although it is possible
to calculate the return of a private equity investment after a fund is liquidated, it is
difficult to find a fair value during the fund’s lifetime. However, these fair values are
necessary to identify the risk profile of private equity investments. Therefore, the sub-
sequent study is only based on listed private equity as it provides the only private equity
investments, which are liquid enough to have realistic price time series. The following
methodology and the results of this section are based on the study which is presented in
detail in [2].
36 Aigner et al.
2.4.1. Characteristics of LPE Return Series

This study is based on monthly log-returns of bonds (represented by the JP Morgan
Global Government Bond Index), stocks (represented by the MSCI World Index), and
listed private equity (represented, as described above, by the LPX 50 Index) between
January 1998 and December 2007. (Data assigned to an asset class in this study always
refers to these according indices.)
Table 2.1 provides the empirical statistics of monthly log-returns. The average
mean for bonds is exceptionally high, especially compared to the performance of
stocks. Combined with the low standard deviation, this would cause a risk–averse
investor to allocate an extremely high portion of his portfolio to bonds. In general, the
question arises whether past returns can be used as an indicator for the future. Therefore,
often experts’ opinions on expected returns are used for asset allocation purposes. To
account for both, the impact of past returns and (market and experts’) expectations,
the Black–Litterman approach [3] is applied to adjust the empirical returns. It allows
to combine absolute and relative forecasts at a confidence level τ with the empirical
expected values µemp (which are assigned a weight of 1−τ). The forecasts are expressed
through q = P · µ, where each row of P and q stands for one particular forecast. P
gives the linear transformations of the asset classes for each forecast, and q the actual
values of these forecasts. The Black–Litterman expectations µBL can then (given that
P is invertible) be calculated via:
µBL = τ · P −1 · q + (1 − τ) · µemp . (2.1)
The assumptions for the Black–Litterman approach employed here at a confidence
level of τ = 0.75 are the following: (1) Bonds are expected to have an annual return
of 3.96%. This number is a combination of expected returns of several bond markets
Table 2.1 Empirical Statistics of Monthly Log-Returns.
Empirical statistics Bonds Stocks LPE
Mean (emp.) 0.0051 0.0056 0.0081

Mean (BL) 0.0037 0.0061 0.0086
Standard deviation 0.0190 0.0410 0.0651
Skewness 0.2012 −0.7789 −0.1106
Excess kurtosis −0.0989 1.1124 2.2936
Autocorrelation: lag 2 −0.0618 −0.0959 0.0501
Autocorrelation of squared returns (lag 1) −0.0622 0.0223 0.1391
5% critical value for autocorrelation 0.1941 0.1941 0.1941
(provided by Bloomberg, 30 August, 2008), weighted according to the constitution

of the index. (2) The equity risk premium is 3.5% (in accordance with several other
studies [8, 9]). (3) The difference of the means of listed private equity and stocks
remains the same. The Black–Litterman adjusted means are given in the second line
of Table 2.1 beneath the empirical means.
It can be observed that the listed private equity index exhibits a lag-1 autocor-
relation, which is significant at the 5%-level. Autocorrelation is a possible sign of
stale-pricing effects. Stale pricing occurs, if the market adjusts only slowly to new
information, which usually is the case when liquidity is low. Of course, the (secondary)
market of unquoted private equity funds is highly illiquid, but also the constituents of
the LPX might suffer from liquidity problems. Regarding skewness and excess kurto-
sis, returns of the MSCI and the LPX 50 tend to be non-normally distributed (which
can be confirmed by a Jarque–Bera test). Table 2.2 shows the correlations between
these three asset classes.
2.4.2. Modeling Return Series with Markov-Switching Processes

A common way of handling those cases where non-normality and/or autocorrelation
occurs is to simulate the returns by a Monte Carlo method: A model describing the
return time series as well as possible is built. As future return time series are not
predictable, this model certainly is based on random processes. Therefore, in a next
step, numerous (in this case 10,000) possible return paths are simulated with this
model. Finally, the required return distributions can be derived from these paths and
the portfolios can be optimized.
2.4.2.1. Markov–Switching models

Markov–Switching models are capable of fitting the previously mentioned empiri-
cal statistics. There are many academic studies emphasizing the benefits of Markov–
Switching models in mapping the economic time series. For more details consult
Timmermann [25]; there are also various applications of Markov–Switching models
Table 2.2 Empirical Correlation Structure

of Monthly Log-Returns.
Correlation Bonds Stocks LPE
Bonds 1 −0.007867 0.012427

Stocks −0.007867 1 0.785161
LPE 0.012427 0.785161 1
38 Aigner et al.
(e.g., in Brunner/Hafner [6]). Here, the Markov–Switching model allowing for state-
independent (first lag) autoregressive dynamics is used.
This Markov–Switching process is defined as follows:
rt,a = µst ,a + φ · (rt−1,a − µst−1 ,a ) + εt,a (2.2)
with st denoting the state of markets at time t, µst ,a denoting the mean return of asset
a ∈ {1, 2, 3} (where 1 =ˆ bonds, 2 =ˆ stocks, 3 = ˆ LPE) in state st , εt = (εt,1 , εt,2 , εt,3 )T
the innovation at time t, εt ∼ N(0, st ), and the autocorrelation parameter φ satisfying
|φ| < 1.
There are two possible states: If the markets are in state 1 then st = 1, if they are
in state 2 then st = 2. The changes of the state st over time are modeled by a Markov
chain. The transition probabilities of changing from state i at time t − 1 into state j at
time t are given by the matrix:

p11 p12
P= , where P(st = j|st−1 = i) = pij .
p21 p22
The whole process is then described by the parameter vector
= (µ1 , µ2 , p12 , p21 , φ, 1 , 2 )
with µ1 , µ2 ∈ R3 , φ ∈ (−1, 1)3 , p12 , p21 ∈ [0, 1] and 1 , 2 ∈ R3×3 the covariance
matrices for the two states 1 and 2.
This model is described in detail in [2]. Another possible way is to apply univariate
processes for each asset and then include the correlation structure between the asset
returns by generating multivariate normally distributed residuals. This would allow
for all possible combinations of different individual market states, where each asset
class can be in one of two states, and therefore has one drawback: As the correlation
would only be accounted for by fitting the residuals, the second big part which is able
to influence the correlation is neglected, which is the correlation occurring from the
state combination. Therefore, instead of modeling independent Markov chains, the
ones resorted to in this study are related to each other in the way that only two meta-
states are allowed for: st = 1 and st = 2, i.e., all assets are in the same state at each
point of time t. Of course, the more market states are taken into account, the better the
empirical moments and autocorrelations may be matched. However, the (quadratic)
increase of the parameter vector itself causes the fitting method to be less efficient.
Furthermore, overfitting problems are more likely to occur. Therefore, as few states as
possible should be used. In this case, two market states already enable the model to
match the empirical parameters in a very good way.
2.4.2.2. Fitting the parameters

The parameters are chosen such that the theoretical statistics of the Markov–Switching
process match the empirical statistics best possible. The background for the method of
moments, which has been applied for the fitting, has been depicted by Timmermann
[25]. The fitting focuses on the first four moments as well as the autocorrelation of lag
1 (which has proven to be significant for LPE). As the autocorrelations for lags 2 and
3 as well as the autocorrelation of the squared returns were not significant for any of
the indices, these statistics are not taken into account.
The results for the parameter vector are given in Table 2.3. These parameters
show some very interesting characteristics: State 1 describes a market scenario, where
bonds perform well, whereas stocks and LPE are in their worse of the two states. State 2
describes a scenario where stocks and LPE perform very well, whereas bonds show
a poor performance. It is even more interesting to consider the standard deviations of
stocks and LPE in the two states: In state 1, the weaker of the two states, the volatility
is much higher than in state 2, where both asset classes have a strong performance.
Regarding the autocorrelation parameter φ, LPE shows the highest value of all asset
classes.
Table 2.4 shows the correlation matrices for the two states st = 1 and st = 2.
(These matrices only give the correlation of the error terms εt and not of the returns
of the asset classes themselves, such as in Table 2.2.) Even these correlation matrices
Table 2.3 Model Parameters for the Assets.

Parameter µ1 µ2 σ1 σ2 φ
Bonds 0.01254 −0.00422 0.01818 0.01508 0.19134

Stocks −0.01236 0.02266 0.04955 0.02000 0.11436
LPE 0.00567 0.01114 0.08727 0.01527 0.32983

0.4512 0.5488
P=
0.4944 0.5056
Table 2.4 State-Dependent Correlations of the Residuals.
st = 1 st = 2
a2 Bonds Stocks LPE Bonds Stocks LPE
a1 Bonds 1 0.06316 0.04029 1 0.69471 0.04500

Stocks 0.06316 1 0.92412 0.69471 1 0.41966
LPE 0.04029 0.92412 1 0.04500 0.41966 1
40 Aigner et al.
show some realistic characteristics, e.g., the correlation between the error terms of LPE
and stocks is much higher (0.92412) for the bad market state 1 than for the “better”
state 2 (0.41966). The parameters are fitted in such a way that the deviation between
the empirical statistics of the time series and the theoretical statistics of the model
is minimized. The (relative) deviation of the theoretical statistics (determined by the
parameters) and the empirical statistics is always smaller than 1% (only the deviation
for the kurtosis of bonds is higher (3.5%)).
2.4.2.3. Simulation of return paths

Having constructed the model, 10,000 possible scenarios of how the return paths of
the assets could develop over 60 months are simulated by applying the previously
expounded process and using the fitted parameters. As st is an ergodic Markov chain,
there exists a unique stationary distribution. The unconditional probability of such a
process being in state 1 is given by π1 = p21 /(p12 + p21 ) and the probability of it being
in state 2 is respectively given by π2 = p12 /(p12 + p21 ). In this case, π1 = 0.4739
and π2 = 0.5261.
The simulated return paths show the same properties as the empirical time series.
The statistics of the simulated paths match the empirical statistics very well. Addition-
ally, most of the assets show a highly significant non-normality. The non-normality
will be one of the main issues in the following, because some very popular concepts in
portfolio theory (such as Sharpe ratio, mean–variance framework) do only account for
the first two moments, i.e., mean and standard deviation. But risk–averse investors are
also sensitive to higher moments because they prefer a higher skewness as well as a
lower excess kurtosis. Therefore, it will be necessary to apply more complex concepts
of portfolio theory.
2.4.3. Listed Private Equity in Asset Allocation

It is the aim to determine the optimal fraction an investor should invest in listed private
equity, or in this particular case, in the LPX 50 Index. The results described here are an
excerpt from [2] and treat the one-year time horizon. However, the described method
can be applied to any time horizon which may be of interest, which is also done for
three and five years in the cited study.
2.4.3.1. Performance measurement

The following section introduces performance measures, which are necessary to eval-
uate and compare the benefits of different asset allocations.
Sharpe Ratio. The Sharpe ratio, see [23, 24], was first introduced by William F.
Sharpe and is one of the most common and intuitive measures. It is defined as follows:
µR − r
SR(R) = (2.3)
σR
with portfolio return R, its mean µR , standard deviation σR , and risk-free rate r.
Despite its intuitive formula (expected excess return per unit of risk in terms of
standard deviation), it has one major shortcoming: Since risk is only measured in
terms of standard deviation, the Sharpe ratio solely uses the first two moments of
the return distribution and ignores characteristics of non-normally distributed returns.
Therefore, it is not appropriate (or at least not sufficient) for return distributions, which
show non-normal characteristics, such as it is the present case.
Omega Measure. The Omega measure, see [22], is based on the idea that an investor
partition returns into gain and loss, i.e., in returns above and below a return threshold
τ. Thus, the Omega measure represents the probability weighted ratio of returns above
and below the threshold or, in other words, upside per downside:
E[R − τ]+
τ (R) = . (2.4)
E[τ − R]+
This definition can be transformed into τ (R) = (µR − τ)/(E[τ − R]+ ) + 1. This
notation reminds of the Sharpe ratio. But unlike the standard deviation for the Sharpe
ratio, the downside potential (as a measure of risk) exhibits the crucial advantage of
considering the whole return distribution of the portfolio return R where R is smaller
than τ (i.e., “left” of the threshold τ). However, the Omega measure still does not allow
to account for risk aversion (as it is not the same as choosing the threshold τ).
Score Value. The score value, see [10, 14], corrects the upside by the weighted
downside and is defined as follows:
ScoreλSc (R) = E[R − τSc ]+ − λSc · E[τSc − R]+ , (2.5)
where λSc defines the risk aversion of the investor. A high λSc stands for a high risk
aversion and vice versa. This performance measure encompasses the complete return
distribution of a portfolio as well as an investor-specific risk aversion parameter λSc . It
is obvious that the higher the Score value the better the portfolio under this measure.
In this study, the parameter τSc for the Score value is set to be equal to the risk-free
rate, i.e., τSc = r. However, the Score value also allows to adjust τSc according to an
investor’s individual preferences.
42 Aigner et al.
2.4.3.2. Portfolio optimization frameworks

After describing how to gauge the performance of portfolios, some criteria are delin-
eated for optimizing them. Like the Sharpe ratio among performance measures, the
mean–variance framework is the most common and intuitive concept in portfolio opti-
mization. Nevertheless, there are some shortcomings of this framework since it only
considers (just like the Sharpe ratio) the first two moments of return distributions.
Mean–Variance Framework. This very popular method of constructing optimal

portfolios by Markowitz [18] assumes that mean and standard deviation embody
sufficient information about the return distribution of a portfolio (which is the case
when dealing with normality). A portfolio is said to be mean–variance efficient when
there exists no other portfolio which has the same (or less) risk and a higher expected
return, or the same (or a higher) expected return accompanied by lower risk. Thus,
one possibility of ensuring mean–variance efficiency of a portfolio is to minimize the
risk under the condition that the expected return of the portfolio is higher or equal to
a target return µtarget . (Another approach would be to maximize the expected return
under the condition that the risk does not exceed a given upper limit.)
To ensure that the entire capital is invested (full-investment constraint), and that
short-selling is not allowed (each portfolio weight has to be non-negative), a set Z of
all possible portfolios is defined:

3
Z := w ∈ R wi = 1, wi ≥ 0 , (2.6)

i
where the vector w = (w1 , w2 , w3 ) denotes the portfolio weights.

T
Considering various levels of target returns µtarget , a large number of efficient

portfolios can be obtained forming a concave efficient frontier in the risk–return space.
It depends on the risk aversion of an investor to decide on which of these portfolios is
the optimal one. As only risk–averse investors are considered, this choice is a trade-
off between risk (measured in terms of standard deviation) and return. The actual
optimization problem can be formulated as
λ
max wT µ − · wT w (2.7)
w∈Z 2
with µ = (µ1 , µ2 , µ3 )T (where µi denotes the expected return of asset i), the
covariance–matrix , and the risk aversion parameter λ.
Power-Utility Framework. The conception of this model is quite commonly applied

(e.g., in Grauer and Hakansson [12]). Within this model, the utility of an investor is
defined as follows:
1
U(R) = (1 + R)γ , γ < 1 (if γ = 0, then U(R) = ln(1 + R)) (2.8)
γ

with R = R(w) = i wi Ri denoting the portfolio return (subject to w), Ri the return
of asset i, and γ capturing the investor’s attitude toward the risk. The aim is to find
those weights w, which maximize the expected utility:
max E[U(R(w))]. (2.9)
w∈Z
Omega Measure and Score Value Frameworks. As the motivation for the Omega
measure and the Score value is to capture more than the first two moments of the
return distributions of a portfolio, the portfolios can be optimized by maximizing
each of these performance measures, and thereby taking advantage of their respective
characteristics. The restrictions are the same as in the other models, i.e., w ∈ Z.
2.4.3.3. Definition of investor types

Optimizing a portfolio requires the risk aversion parameters λ, γ, λSc as well as the
return threshold τ. The values of these parameters represent different investor types
and are crucial when optimizing the weights of a portfolio. In order to show the
effects of private equity in asset allocation, three benchmark portfolios (for three typ-
ical investors) are constructed, which only consist of bonds and stocks. According to
the presented optimization problems, each typical investor is represented by a vector
of parameters (λ, γ, λSc , τ). The parameters are chosen such that each optimization
problem leads to the same benchmark portfolio for the corresponding investor. The
following benchmark portfolios are chosen to characterize these investors when solely
investing in bonds and stocks: A conservative investor A who invests 70% in bonds
and 30% in stocks, an investor B whose strategy is an equally weighted portfolio of
50% bonds and 50% stocks and an investor C who is willing to take higher risks and
invests only 30% in bonds and 70% in stocks.
The parameters are listed in Table 2.5 for the according benchmark portfolios.
(Note that the parameters depend on the time horizon.) For those parameters where
higher parameter values stand for a higher risk aversion (λ and λSc ), investor A has
greater values than investor C, and vice versa (for γ). As τ represents a threshold, which
the investor sets to distinguish between upside and downside, investor C demands
higher returns to consider them as “upside returns” than investor A.
Table 2.5 Risk Aversion Parameters

of the Different Investor Types.
Investor: A B C
λ 8.1756 3.1042 1.9158

γ −8.0317 −3.0455 −1.8764
τ 0.0090 0.0332 0.0389
λSc 4.5397 2.0463 1.7551
44 Aigner et al.
2.4.3.4. Optimization of portfolios

The goal is to examine, if and to what extent investments in listed private equity
increase the performance of a portfolio. For this purpose, returns of the assets were
simulated, performance measures as well as models to optimize portfolios were
introduced and three different investor types defined. This section will apply all these
aspects. As stated in the optimization problems, an investor optimizing his portfolio at
the beginning of the period of one year is considered. The investor has neither the pos-
sibility of reallocating nor materializing the returns until the end of his investment hori-
zon. Hence, no transaction costs occur except for the initial purchase and the liquidation
after one year. Due to the high liquidity of the underlying assets, these costs are assumed
to be negligible. Four different portfolios for each investor type are considered: Each
of them is optimized by one of the four previously described optimization models.
Table 2.6 shows the optimal portfolios, which are obtained by applying all opti-
mization models to all possible combinations of investor types A, B, and C for
Table 2.6 Portfolio Weights and Performance Measures

of Optimal Portfolios (One Year).
Framework: MV PU Omega Score
Portfolio weights
Bonds 0.7000 0.7000 0.7000 0.7000

A Stocks 0.3000 0.3000 0.3000 0.3000
LPX 50 0.0000 0.0000 0.0000 0.0000
Bonds 0.5394 0.5441 0.5363 0.5334
B Stocks 0.3852 0.3718 0.3708 0.3489
LPX 50 0.0754 0.0841 0.0929 0.1177
Bonds 0.3880 0.3944 0.3582 0.3101
C Stocks 0.4434 0.4252 0.4282 0.4114
LPX 50 0.1686 0.1803 0.2135 0.2785
Performance measures
Sharpe 0.1612 0.1612 0.1612 0.1612

A Omega 4.4783 4.4783 4.4783 4.4783
Score 0.0165 0.0165 0.0165 0.0165
Sharpe 0.2034 0.2038 0.2052 0.2071
B Omega 2.0181 2.0186 2.0190 2.0175
Score 0.0437 0.0438 0.0438 0.0438
Sharpe 0.2148 0.2148 0.2156 0.2157
C Omega 1.7631 1.7637 1.7648 1.7621
Score 0.0493 0.0494 0.0495 0.0496
a time horizon of one year. There are several conclusions to be drawn from this
tables: There is almost always the same order of how much weight the performance
measures assign to the LPX 50 Index: The fractions increase as follows: mean–variance
framework < power–utility framework < Omega measure framework. The highest
fraction for the LPX 50 is always recommended by the Score value framework, whereas
the mean–variance framework allocates the smallest portions to listed private equity
among all optimization frameworks.
As theory suggests, the higher the risk aversion of the investor the smaller the
investment in listed private equity, because this asset is riskier than bonds and stocks.
In fact, the most risk–averse investor A would not consider a private equity investment
at all. Investor B puts lower fractions into the LPX 50 (7.5–11.8%) than investor C
(16.9–27.9%).
Another interesting issue to examine is whether stocks or bonds lose weight when
the LPX 50 index is included in the portfolio. Overall, it can be observed that bonds
hardly change their weight, and thus almost the whole weight of the LPX 50 is drawn
from the stocks. It is rather the case that the weight of bonds slightly increases when
taking listed private equity into account. The least risky asset class, bonds, is regarded
as a counterpart for the highly risky listed private equity for two reasons: its low risk
itself (measured in any risk measure) and the low correlation with both stocks and
private equity. Figures 2.5–2.8 show the portfolio allocation and the risk–aversion
parameters in different optimization frameworks subject to the standard deviation.
Figure 2.5 Optimal portfolio weights in the mean–variance framework.

46 Aigner et al.
Figure 2.6 Optimal portfolio weights in the power–utility framework.
Figure 2.7 Optimal portfolio weights in the Omega measure framework.

Figure 2.8 Optimal portfolio weights in the Score value framework.
2.5. CONCLUSION
Private equity is a versatile asset class. It comprises investments in companies in

different stages (early/expansion/late stage), by choosing an appropriate financing
(equity/debt/mezzanine financing) and divestment strategy (e.g., initial public offering
or trade sale). Private equity investments are usually long-term investments. Among
other reasons, this is due to the fact that a prolonged (and expensive) due diligence
period is necessary to obtain the information needed to make an investment decision.
Additionally, private equity funds tend to buy rather big stakes of unlisted companies
so that they can also control the decisions of the target company’s management. Hence,
the general partner’s level of expertise in the business area of the target company during
the whole investment process is absolutely crucial for the success of a private equity
fund. Furthermore, it is also important for the general partner to be well connected in
the relevant markets in order to obtain all the relevant information about a non-listed
company.
Most investors invest in private equity via funds or even funds-of-funds since
they themselves do not have such a high level of expertise. However, since there is no
mark-to-market of unquoted companies, it is difficult to find a fair price for a stake
in a fund during its lifetime. This yields a very illiquid secondary market and, thus, it
is not possible to get reliable time series, e.g., for the risk measurement of a private
48 Aigner et al.
equity fund (or fund-of-funds). For this reason, the conducted study about the benefits
of private equity vehicles is limited to listed private equity only.
Monthly log returns of the LPX50 total return index showed a significant non-
normality and autocorrelation. Capturing these characteristics is not possible with stan-
dard approaches. Therefore, the concept of Markov–Switching models is introduced
to model more realistic return time series in order to find optimal asset allocations.
Depending on the degree of risk aversion of an investor and the optimization method
used, listed private equity should have a weight between 0% and 27.9% in an optimal
portfolio, where only the most risk–averse investor type is supposed to ignore listed
private equity for a one-year investment horizon.
References
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drives PE? Analyses of success factors for private equity funds. The Journal of Private
Equity, (Fall), pp. 63–85.
[2] Aigner, P, G Beyschlag, T Friederich, M Kalepky and R Zagst (2009). Optimal risk-return
profiles for portfolios including stocks, bonds, and listed private equity (submitted).
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Boston Consulting Group, Inc., and the IESE Business School of the University of Navarra.
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96, 75–111.

ALTERNATIVE REAL ASSETS

IN A PORTFOLIO
CONTEXT
3
WOLFGANG MADER∗ , SVEN TREU† and
SEBASTIAN WILLUTZKY‡
risklab GmbH, Seidlstraße 24–24a, 80335 München, Germany

∗
wolfgang.mader@risklab.com
†
sven.treu@risklab.com
‡
sebastian.willutzky@risklab.com
In this chapter, we are introducing the asset class “Alternative Real Assets”. This asset class
provides access to “real” investment opportunities, real meaning both partially inflation protected
and solid, via limited partnership fund structures. This (sub-)asset class comprises fund vehicles
that invest, for example, in infrastructure, shipping, or renewable energy projects. For some of
these alternative real assets, financial incentives are provided, such as preferential feed-in tariffs
for solar-generated electricity.
We discuss alternative real assets, including a comparison to other asset classes and a descrip-
tion of distinctive features, with a focus on photovoltaic investments. The bottom-up modeling
approach of individual photovoltaic projects and the approach to incorporate these investments
in portfolio analytics are presented. Based on a comprehensive framework, we are finally able
to evaluate the benefits of photovoltaic investments in a multi-asset portfolio.
Investing in photovoltaic facilities is environmentally supportive. We are able, as well, to
show that under reasonable assumptions, financing solar plants is an attractive asset class, both
stand-alone and in a portfolio context.
51
52 Mader et al.
3.1. INTRODUCTION
This chapter introduces the asset class “Alternative Real Assets.” Alternative real assets
provide access to investment opportunities in special forms of project finance, usually
via limited partnership structures. This asset class comprises fund vehicles that invest,
for example, in infrastructure, shipping, or renewable energy projects. For some of
these alternative real assets, financial incentives are in place, such as preferential feed-
in tariffs for solar-generated electricity.
The analysis of photovoltaic investments is the focus of this article. A bottom-up
modeling of investments in photovoltaic facilities, as well as the approach to incorpo-
rate these investments in portfolio analytics, is presented. Based on a comprehensive
framework, we are able to evaluate the benefits of photovoltaic investments in a multi-
asset portfolio. Empirical data and realistic modeling assumptions are the result of
a joint research project with a leading provider of closed-end funds in the area of
photovoltaic investments.
This chapter is organized as follows. Section 3.2 provides an introduction to alter-
native real assets. In Sec. 3.3, we present our bottom-up approach to model alternative
real asset investments. Section 3.4 describes how to incorporate these investments to a
portfolio. It shows the results of integrating photovoltaic investments into a traditional
portfolio, including changes in portfolio statistics and the corresponding substitution
effects. A conclusion is given in the last section.
3.2. OVERVIEW ON ALTERNATIVE REAL ASSETS
Broadly speaking, asset classes contain investments with similar features including
their risk and return characteristics and their sensitivity toward major market fac-
tors. The investment universe is usually divided into traditional asset classes and
non-traditional or alternative asset classes that emerged over the last few decades.
Traditional asset classes include equities, nominal government, or corporate bonds.
Examples for non-traditional or alternative asset classes are private equity or hedge
fund investments.
The rationale for investing in the different asset classes varies broadly, which is in
turn the reason why investors should diversify their asset allocation. For equity invest-
ments, a main investment objective is to participate in the growth potential and payout
of listed companies. The rationale for bond investments includes income generation,
deflation protection, and reduction of portfolio volatility.
Traditional real assets include commodities, inflation-linked bonds, and real estate
investments (direct or indirect, but not listed real estate investments). The categoriza-
tion to this asset class subset is usually based on either the inflation protection feature
Alternative Real Assets in a Portfolio Context 53
such as real return, or the tangibility of the assets (see [3], p. 20, for a definition of real
assets). Alternative real assets are represented by investments in shipping, aviation,
infrastructure, or renewable energy facilities like photovoltaic or wind power plants.
The real assets that provide the necessary cash flows may be roads, ships, or solar
plants. Therefore, alternative real assets provide direct exposure to specific projects
and the corresponding “real facilities” but no exposure to a listed company’s capital
structure. Due to the project finance character, alternative real assets are not very liquid
investments, even though secondary markets are already emerging. As revenues of the
financed projects are often linked to inflation, most alternative real assets provide some
inflation protection.
In the following, we will focus on investments in solar power plants. This kind
of alternative real assets is characterized by cash flows that are mainly driven by
solar radiation and preferential feed-in tariffs. These cash flows are often linked to
inflation and show a sensitivity to interest rates due to the partial debt financing of the
photovoltaic projects. More details on the modeling of photovoltaic investments are
given in the next section.
3.3. MODELING PHOTOVOLTAIC INVESTMENTS
3.3.1. General Approach

When developing models for alternative real assets, one might encounter problems
due to the special design of this asset class. A top-down approach is usually oversim-
plifying. It is not appropriate to link alternative real asset returns to the returns of the
equity market using the capital asset pricing model (CAPM), as we do not find listed
companies that are comparable to these highly individual projects. However, this is
the only approach taken in literature concerning the analysis of alternative real assets
thus far. For example [12], apply the CAPM approach to shipping investments.
For further comprehension, a few words on the photovoltaic technique: photo-
voltaic is the direct generation of electricity out of global solar irradiance. This method
of power generation is generally implemented through semiconductor panels, which
are making use of a special case of the photo-electric effect. These solar panels are
arranged in large arrays with additional infrastructure, so-called photovoltaic solar
power plants. Using sunlight as the major resource, these facilities convert global irra-
diance into electricity in an environment-friendly way and are therefore categorized
as renewable energy power plants.
As a matter of fact, the return structure of limited partnership funds financing pho-
tovoltaic projects is completely different from stock returns of solar sector companies
(a company producing solar panels, for example). On the one hand, we have the direct
54 Mader et al.
exposure to a specific project with a well-defined revenue and cost structure, on the
other hand we have exposure to a broad mix of risk factors that drive the stock returns
of a listed company:
• Capital structure of the company
• Balance sheet effects
• General economic environment
• Change in exchange rates
• Differing expectations of market participants
• Analyst appraisals of profit expectations
Therefore, we believe that a different methodology than the top-down CAPM approach
is required, when dealing with this kind of project finance. However, in relevant aca-
demic and practitioner publications, frequently top-down approaches are used for eval-
uating the alternative real assets.
Based on expert information from a well-known German initiator of photovoltaic
projects (we would like to thank KGAL [KG Allgemeine Leasing GmbH & Co.] for
valuable insights to the financial modeling of solar plants), we analyzed the revenue
and cost structure reflecting the return profile of individual solar power plants. Thus,
we were able to identify crucial and cash flow relevant aspects of photovoltaic projects
that should be covered by an appropriate model:
• Revenues of the sale of electricity
• Cost of acquisition
• Operating expenses
• Interest on debt capital
• Tax payments and interest subsidy
Modeling these building blocks properly is at the heart of our bottom-up approach.
Reference [7] follows a similar bottom-up approach to derive the cash flows resulting
from shipping investments. However, they combine this procedure with a CAPM-
approach to finally be able to price a shipping investment. Recently, at the stock
market exchanges of Hamburg and Hannover, a ship fund index is calculated using a
bottom-up methodology. The index calculation is described in [14].
3.3.2. Definition of the Investment Project

As we do not focus on evaluating a highly specific photovoltaic project for a certain
investor, we set up a typical photovoltaic project that disregards individual, location-
dependent features of an existing photovoltaic power station, and instead accentuates
general properties of a typical project in a certain region. Solar power plants are usually
set up in countries supporting renewable energy projects by an attractive compensation
for feeding “clean” electricity into the grid. Such feed-in tariffs are guaranteed by
local law and paid by the government, securing cash inflow. In some countries, the
compensation is even linked to local consumer price indices and accordingly provides
partial inflation protection to potential investors.
Due to generous (inflation-linked) government compensations and a high level
of global irradiance, Spain is a favored country for building up photovoltaic facilities
and feeding the produced electricity into the local grid. For further comprehension,
global irradiance is the total incoming solar radiation on a horizontal plane at the
Earth’s surface, i.e., the incoming solar radiation after scattering effects in the Earth’s
atmosphere. Therefore, our representative photovoltaic project is located in Spain and
we have chosen a corresponding parametrization. This includes a project duration of
25 years, which corresponds to the maximum duration of the attractive feed-in tariffs.
When following a bottom-up approach, it is absolutely necessary to model the
project’s properties and the corresponding dependencies (especially the dependencies
on stochastic risk factors) with a high level of detail. To be able to model the cash
flow structure in an appropriate way, we set up a comprehensive bottom-up framework
covering all revenue and cost-related features of the sample solar plant. An overview
of the framework components and properties can be found in Table 3.1.
A special focus of our analysis is on the simulation of stochastic risk factors that
drive the revenue and the cost side of the photovoltaic project. The key risk factors
and their dependencies to various components of the bottom-up framework are listed
in Table 3.2.
These risk factors have to be modeled and simulated in an integrated approach.
This allows us to conduct a multi-scenario analysis of the inherent risk factors, the
Table 3.1 Comprehensive Framework for Bottom-Up Modeling.
Revenue Modeling of the generation of electricity out of solar radiation, and the
corresponding feed-in tariffs, including inflation-indexed tariff adjustments
Costs Considering acquisition and operating costs, as well as inflation-driven increase
over time
Financing Modeling of equity, debt capital, and shareholder debt capital, as well as
required liquidity reserves
Tax Considering tax payments on company level, tax deductibility of interest
payments on debt and shareholder debt, and tax loss carry-forwards to future
periods
Facility Considering annual power loss of the solar panels due to degradation effects,
liquidation proceeds are on par with deconstruction costs at project
termination
56 Mader et al.
Table 3.2 Dependencies of Bottom-Up

Framework on Key Risk Factors.
Global irradiance −→ Revenue

Inflation −→ Revenue, Costs
Nominal interest −→ Financing
sample photovoltaic project and a portfolio consisting of traditional assets and the
photovoltaic project.
3.3.3. Modeling of Risk Factors

3.3.3.1. Economic factors
The theoretical framework used for the analysis of alternative real assets in a portfolio
context is the risklab Economic Scenario Generator (ESG), see [16]. This model incor-
porates fundamental macroeconomic factors to describe the evolution of interest rates
and equities. Using a cascade structure, it captures the long-term economic relation-
ships while allowing for short-term deviations. This setting allows for an integrated
modeling of financial markets, delivering economically meaningful, and consistent
scenarios.
We assume an arbitrage-free, frictionless financial market in continuous time t ∈
[0, T ∗ ], where the uncertainty in the market is described by the complete filtered
probability space (, F, F, IP ). Details on this framework can be found in [17]. We
t
use a non-defaultable money market account defined by P(0, t) = exp( 0 r N (s)ds) as
numeraire, where the process {rN (t)}t∈[0,T ∗ ] is the nominal short rate. We assume the
existence of a measure Q equivalent to IP, under which all discounted price processes
of the financial market under consideration are martingales. The before mentioned
cascade structure is now imposed on this foundation to incorporate long-term economic
dependencies.
The model’s first cascade comprises inflation {i(t)}t∈[0,T ∗ ] and economic growth
{w(t)}t∈[0,T ∗ ] , which are modeled by Vasicek processes, introduced in [15]. Under the
equivalent martingale measure Q, they are specified as follows:
di(t) = [θi − âi · i(t)]dt + σi dWiQ (t)
dw(t) = [θw − âw · w(t)]dt + σw dWwQ (t)
with the positive real numbers θi , θw , âi , âw , σi , σw and the independent standard Brow-
nian motions WiQ and WwQ .
The second cascade contains the interest rate processes. The real short rate
{r(t)}t∈[0,T ∗ ] is modeled by a two factor Hull–White model. Its dynamic is specified as
dr(t) = [θr (t) + brw · w(t) − âr · r(t)]dt + σr dWrQ (t)
with the positive real numbers brw , âr , and σr , the time-dependent deterministic func-
tion θr and the standard Brownian motion WrQ , independent of the Brownian motions
mentioned before. The nominal short rate {rN (t)}t∈[0,T ∗ ] is defined as the sum of real
short rate and inflation, i.e.,
r N (t) = r(t) + i(t).
The term structure of interest rates can then be derived by the zero-coupon bond prices
obtained from this setting. As shown in [16], p. 4254f, the price of a zero-coupon bond
with maturity t < T ≤ T ∗ is given by
P(t, T ) = exp(A(t, T ) − B(t, T )r(t) − C(t, T )i(t) − D(t, T )w(t)),
where
1
B(t, T ) = (1 − exp(−âr (T − t)),
âr
1
C(t, T ) = (1 − exp(−âr (T − t)),
âi

brw 1 − exp(−âr (T − t)) exp(−âw (T − t)) − exp(−âr (T − t))
D(t, T ) = · + ,
âr âw âw − âr
T
1 2
A(t, T ) = (σ B(l, T )2 + σi2 C(l, T )2 + σw2 D(l, T )2 ) − θr (l)B(l, T )
t 2 r

− θi C(l, T ) − θw D(l, T ) dl.
Using Girsanov’s Theorem, the model equations can be derived under the real measure
IP instead of the equivalent martingale measure Q by replacing WiQ , WwQ , WrQ with
the independent standard Brownian motions Wi , Ww , Wr and using the parameters
ai = âi − λi σi2 , aw = âw − λw σw2 , and ar = âr − λr σr2 . λi , λw , and λr are obtained by
the change of measure, as shown in [10]. As can be seen, the term structure of interest
rates is driven by the real short rate process, as well as the underlying macroeconomic
factors of economic growth and inflation.
The third cascade contains equity assets. The equity prices {StE }t∈[0,T ∗ ] are driven
by the following dynamics:
dS E (t) = [αE + bEr r(t) − bEi i(t) + bEw w(t)]S E (t)dt + σE S E (t)dWE (t),
where bEr , bEi , bEw , and σE are positive real numbers, αE ∈ R, and WE (t) is a standard
Brownian motion, independent of those mentioned above.
3.3.3.2. Non-economic factors

The final model component needed, which will add to the basic framework described
above, is yearly global irradiance on a horizontal surface {Y(t)}t∈{0,1,...,T ∗ } , which is the
58 Mader et al.
starting point for the generation of electricity in a solar plant. An appropriate starting
point for the modeling approach is average monthly global irradiance. Having a higher
frequency will, apart from data availability issues, increase the noise component of
the model, but not have a different impact on at most monthly simulated cash flows
generated by the photovoltaic plant. As the irradiance model component independently
adds to the basic framework, and the frequency of our data is also monthly, we develop
a discrete-time model. The following sections now present the building blocks for the
derivation of a discrete-time model for yearly global irradiance.
3.3.3.3. Historical analysis of monthly global irradiance

To model monthly global irradiance on a horizontal surface, {Y M (m)}m∈{1,...,12·T ∗ } ,
where m indicates the month, we use a simple Angström-type equation, where bright
sunshine duration is related to global irradiance. An overview of Angström-type equa-
tions to model global irradiance on horizontal surfaces is given in [1]. We follow a
parsimonious approach, where we use a sinusoidal function to describe monthly global
irradiance. This offers the advantage of not requiring information on bright sunshine
hours, day length, and extraterrestrial radiation. We specifically assume monthly global
irradiance to follow the process

2π ∗
Y M (m) = A + B sin m − F + (m), (3.1)
12
where A is the average monthly global irradiance, B is the amplitude of seasonal
radiation variation, F is the phase angle in radian measure, i.e., the necessary shift
of the function on the time axis, and m∗ ∈ {1, 2, . . . , 12} is the number of a specific
month in the year, i.e., the number of January is 1, etc., see [2]. The zero-mean pro-
cess {(m)}m∈{1,...,12·T ∗ } represents random fluctuations around the seasonal trend of
monthly global irradiance. We use a least squares method to estimate the parameters A,
B, and F in (3.1), and conduct the estimation on annualized monthly global irradiance
data ranging over 12 years from 1/1982 to 12/1993 for several locations in Spain. (For
nonlinear least squares estimation, see e.g., [9].) Our data source is the online archive
of the U.S. Department of Energy’s National Renewable Energy Laboratory and the
World Radiation Data Center (http://wrdc-mgo.nrel.gov/). The estimated model pro-
duces a high degree of variance explanation, with R2 > 0.9 for all locations. R2 is
calculated as 1 − Var(ˆm )/Var(Ŷ (m)), where Ŷ (m) denotes the observed radiation
series. Exemplarily for the location Toledo, the fitted series and the original series can
be seen in Fig. 3.1.
The fitted series is close to the original series with the model explaining 98%
of the variation in the original series. The analysis of the model residual time series
{ˆm }m∈{1,...,12·T ∗ } shows skewed distributions. The estimated density of residuals for
3000
2500
Annualized monthly solar irradiance
2000
1500
1000
500
0
0 10 20 30 40 50 60 70 80
Time in months
−3
x 10
4
3.5
2.5
Estimated Density
1.5
0.5
0
−400 −300 −200 −100 0 100 200 300 400 500
Monthly global solar irradiance
Figure 3.1 Left: Original (continuous line) and fitted (dashed line) annualized monthly global
radiation series. Right: Estimated density of residuals.
the location Toledo is shown in Fig. 3.1. The density was estimated using Gaussian
kernel smoothing, i.e., the density estimator
T
1 1 − (Y −Ŷ 2(t))2
fˆ(Y ) = √ e 2h
Th t=1 2π
60 Mader et al.
1
was applied to the observed data series, where the bandwidth used was h = 3T4 5 σ,
and σ was obtained using the median absolute deviation estimator. (More informa-
tion on kernel smoothing can be found in [4]). To capture the skewness in the fluc-
tuation around the average seasonal global irradiance, we specify the noise process
{m }m∈{1,...,12·T ∗ } to follow a Markov switching model, i.e.,
(m) = µM
1 + X (m)(µ2 − µ1 )
M M M
+ (σ1M + XM (m)(σ2M − σ1M )) · uM (m), (3.2)

+
where µM 1 , µ2 ∈ R, σ1 , σ2 ∈ R , {X (m) : X (m) ∈ {0, 1}}m∈{1,...,12·T ∗ } is a time-
M M M M M
M
homogenous Markov chain and u (m) is the increment of a standard Brownian motion,
independent of XM (m). Details on Markov Switching Models can be found in [13].
To obtain parameter estimates, we are applying a maximum likelihood approach to
the residual time series. (For the maximum likelihood estimation of Markov switching
models, see [8].) The residual distribution from the estimated model, obtained by a
Monte Carlo simulation, is shown for Toledo in Fig. 3.2. We conduct a two-sample
Kolmogorov–Smirnov test on the simulated and the original monthly global irradi-
ance series, which does not show evidence against both series coming from the same
distribution. (For the two-sample Kolmogorov–Smirnov test, see [6].)
The out-of-sample performance of the estimated model can be seen in Fig. 3.3,
exemplarily for Toledo. The original time series are shown along with the 1%, 50%,
and 99% quantiles of a simulation of 1000 paths following (3.1) and (3.2).
9000
8000
7000
6000
Frequency
5000
4000
3000
2000
1000
0
−800 −600 −400 −200 0 200 400 600 800 1000
Annualized monthly global irradiance results
Figure 3.2 Histogram of simulated monthly global irradiance residuals.

3500
3000
Annulized monthly global irradiance
2500
2000
1500
1000
500
0
0 5 10 15 20
Time
Figure 3.3 Original series (dots) and annualized monthly global irradiance quantiles (barred
lines).
3.3.3.4. Monte Carlo analysis of yearly global irradiance

We use the results for monthly global irradiance to analyze yearly global irradiance,
which is needed for the analysis of the photovoltaic investment. The global irradiance
of a specific year is just the sum of the monthly global irradiance over that year.
Formally, the global irradiance of year t, Y(t), with t ∈ { 12
m
: m ∈ {1, . . . , 12 · T ∗ } ∧ m
mod 12 = 0} is given by

12
Y(t) = Y M (12t − j + 1). (3.3)
j=1
We now use the model for Y M (m) to obtain the distribution of Y(t) by simulating
1000 trajectories of monthly global irradiance, each over a time span of 25 years.
By calculating yearly radiation on the simulated processes according to (3.3), we
generate 1000 paths of yearly global irradiance with 25 observations per path. The
resulting distribution can be seen in Fig. 3.4 for Toledo. Compared to monthly global
irradiance the skewness is reduced, but retained. The results we obtain for yearly
global irradiance are similar to the published information on average yearly global
irradiance, as available for example through radiation maps shown in [11] or offered
on the website www.meteonorm.com, which provides a comprehensive meteorological
reference. Table 3.3 below shows the means and relative standard deviations, i.e., the
62 Mader et al.
Figure 3.4 Histogram of simulated yearly global irradiance.
Table 3.3 Yearly Global Irradiance Statistics for Locations in Spain.
Location Mean in KWh/m2 Rel. standard deviation (%) R2 (%)
Toledo 1,655.96 2.67 95.9

Caceres 1,661.07 2.86 95.3
Logrono 1,407.48 3.06 95.5
Madrid 1,602.93 3.05 96.1
Murcia 1,698.89 2.00 96.9
Mallorca 1,556.73 1.92 97.7
Santander 1,205.08 3.12 94.9
Sevilla 1,658.85 1.95 97.2
standard deviation divided by the mean, resulting from the simulation of yearly global
irradiance for several sites, as well as the R2 -values of the estimated model.
Comparing means and standard deviations with the information in [11] shows them
to be in line with their data. The skewness of the distributions for the different locations
is very similar; the distributions vary mainly in location and scale. For the following
analysis of photovoltaic investments, we choose Toledo as a reference for yearly global
irradiance on a horizontal surface, because it shows average characteristics of global
irradiance in Spain, and is located close to a large number of existing solar plants.
3.4. PHOTOVOLTAIC INVESTMENTS

IN A PORTFOLIO CONTEXT
3.4.1. Setting the Portfolio Context

We analyze the impact of photovoltaic investments in a portfolio context by eval-
uating the changes in risk/return profiles. Apart from photovoltaic investments, the
asset class universe underlying this analysis comprises equity and bonds, repre-
sented by a bond index, which is constructed by periodically buying and selling
bonds such that a constant modified duration of approximately six years is achieved.
(The necessary bond prices are determined by the stochastic evolution of interest
rate term structures generated using the integrated economic model.) The specific
characteristics of these asset classes in terms of risk (measured by the standard
deviation of annual returns) and expected return (measured by the mean of annual
returns) over the considered investment horizon of 25 years are given in the following
Table 3.4.
Three types of investors are characterized by three different initial asset alloca-
tions. These allocations, presented in Table 3.5, are the starting point for our analysis.
The three allocations represent different risk (and return) preferences with 10%,
20%, and 30% equity allocations. Comparing the risk and return figures for the “10%
Equity” portfolio in Table 3.5 to the pure bond profile in Table 3.4, we can already see
the benefits of diversification, i.e., an increase in expected return at the same level of
expected risk when a 10% allocation in bonds is substituted by equities.
Based on the three initial portfolios in Table 3.5, we evaluate the changes in risk
and expected return figures when adding a maximum of 5%, 15%, or 25%, and up to
100% of photovoltaic investments.
Table 3.4 Traditional Asset Classes.

Return p.a. (%) Risk p.a. (%)
Equity 7.7 14.8

Bonds 4.3 3.5
Table 3.5 Initial Asset Allocations.

Initial allocation Equity (%) Bonds (%) Return p.a. (%) Risk p.a. (%)
“10% Equity” 10 90 4.9 3.5

“20% Equity” 20 80 5.3 4.1
“30% Equity” 30 70 5.6 5.1
64 Mader et al.
3.4.2. Including Photovoltaic Investments in a Portfolio

As a mark-to-market modeling of a photovoltaic investment is impossible without
very strong assumptions (e.g., regarding the appropriate discount rate), we make
use of an approach that does not require a pricing of the portfolio at each point
in time. Furthermore, we attached importance to a realistic modeling of the invest-
ment itself. Starting with a predefined initial portfolio consisting of the traditional
assets, i.e., equities and bonds, a portion of an investment in a photovoltaic project
is added. Incoming cash flows from the photovoltaic project are reinvested into
the traditional part of the portfolio. In each time step, the reinvestment is allo-
cated according to the weights of the traditional assets in the portfolio. As a result
of this approach, the absolute allocations of the photovoltaic investment decrease
over time.
A reinvestment of the dividends from the photovoltaic investment in other (new)
projects, in order to maintain the relative photovoltaic investment, would imply arbi-
trary availability and divisibility. An investor would not enter into new photovoltaic
projects on an (semi-)annual basis as dividends flow back.
We perform the portfolio analysis on log-returns, which offers, for example,
the advantage that multi-period log-returns can be calculated as the sum of the
single-period log-returns. Due to the before-mentioned mark-to-market problems
of photovoltaic investments, we cannot calculate portfolio returns before the end
of the investment horizon. Using log-returns allows us to easily transform observ-
able total return characteristics over a period of several years to more common per
annum values. Consider therefore portfolio p, which comprises photovoltaic invest-
ments. Thus, the portfolio value, and therewith the single-period returns cannot be
calculated during the investment horizon, as the value of the photovoltaic invest-
ment is unknown during the investment horizon. Assume, nevertheless, that the
(unobservable) single-period log-returns {rp,i } for the periods i = 1, . . . , n satisfy
Var(rp,i ) = σp2 ∀ i = 1, . . . , n and Cov(rp,i , rp,i−j ) = kp (j) · σp2 for j = ±1, ±2, . . . .
total
The multi-period or total log-return rp,1 →n is obtained by summing up the single-period
log-returns, i.e.,

n
→n =
total
rp,1 rp,i .
i=1
Given these assumptions, it is easy to show that (for this result compare also [5],
p. 49.)
 
n−1

 j
total
Var(rp,1 →n ) = n · 1 + 2 1− · kp (j) · σp2 , (3.4)
j=1
n
with
total n
Var rp,1 →n = Var(rp,i ) + Cov(rp,i , rp,j )
i=1 i =j

n
i−1
= Var(rp,i ) + 2 · Cov(rp,i , rp,j )
i=1 j=1
 

n
i−1
= σp2 + 2 · (σp2 · kp (i − j))
i=1 j=1
 

n
i−1
= σp2 n + 2 · kp (i − j) .
i=1 j=1
Now, defining k := i − j, we have

n
i−1
n
i−1
kp (i − j) = kp (k)
i=1 j=1 i=1 k=1

n−1
n
= kp (k)
k=1 i=k+1

n−1
= (n − k) · kp (k),
k=1
where we used the fact that 1 ≤ i ≤ n, 1 ≤ k ≤ i − 1 ⇔ 1 ≤ k ≤ n − 1, k + 1 ≤ i ≤ n

in the second equality. Factoring out n, Eq. (3.4) follows. Using this result, we define
a volatility adjustment factor
 
n−1

j
α := 1 + 2 1− · kp (j) . (3.5)
j=1
n
Thus, knowing the degree of autocorrelation and having for instance yearly periods
allow us to calculate the annualized volatility from total volatility by dividing the
total volatility by the square root of the number of years adjusted for the degree
of autocorrelation by the factor 1/α. Assuming the absence of autocorrelation, only
the observable initial portfolio value and the observable portfolio value at the end
of the investment horizon are needed to calculate single-period portfolio log-return
volatility. The dependence of cash flows generated by a solar power plant over time
should mainly be driven by their dependence on inflation and interest rates, which
both have a negative impact on the cash flows, and both show positive autocorrelation.
Thus, one would expect positive autocorrelation, if any, in the single-period returns
66 Mader et al.
of a photovoltaic investment. Positive autocorrelation is increasing α defined in (3.5),

and therefore would increase the measured total variance of a portfolio including
photovoltaic investments. Scaling the total variance by the number of periods will
then overstate the single-period variance, which makes our assumption of absence of
autocorrelation and therewith the results of our analysis conservative.
3.4.3. Results
Tables 3.6–3.8 present the results of our portfolio optimizations for the three initial
allocations “10% Equity,” “20% Equity,” and “30% Equity.” Every table shows the
resulting optimized portfolios for similar expected risk or similar expected return
Table 3.6 Results for the Initial Allocation “10% Equity.”
Substitution
Allocations Statistics w.r.t. “10% Equity”
Portfolio PV (%) E (%) B (%) Return (%) Risk (%) PV (%) E (%) B (%)
“10% Equity” 0 10 90 4.9 3.5 — — —
“HR 5% PV” 5 13 82 5.1 3.5 +5 +3 −8

“HR 15% PV” 15 15 70 5.4 3.5 +15 +5 −20
“HR 25% PV” 25 15 60 5.6 3.5 +25 +5 −30
“LR 5% PV” 5 7 88 4.9 3.3 +5 −3 −2
“LR 15% PV” 15 5 80 5.0 3.1 +15 −5 −10
“LR 25% PV” 25 4 71 5.2 2.9 +25 −6 −19
Substitution
“20% Equity” 0 20 80 5.3 4.1 — — —
“HR 5% PV” 5 21 74 5.4 4.1 +5 +1 −6

“HR 15% PV” 15 21 64 5.7 4.1 +15 +1 −16
“HR 25% PV” 25 21 54 5.9 4.1 +25 +1 −26
“LR 5% PV” 5 17 78 5.3 3.8 +5 −3 −2
“LR 15% PV” 15 12 73 5.3 3.3 +15 −8 −7
“LR 25% PV” 25 7 68 5.3 3.0 +25 −13 −12
Substitution
“30% Equity” 0 30 70 5.6 5.1 — — —
“HR 5% PV” 5 30 65 5.8 5.1 +5 0 −5

“HR 15% PV” 15 29 56 6.0 5.1 +15 −1 −14
“HR 25% PV” 25 28 47 6.2 5.1 +25 −2 −23
“LR 5% PV” 5 27 68 5.6 4.7 +5 −3 −2
“LR 15% PV” 15 21 64 5.6 4.1 +15 −9 −6
“LR 25% PV” 25 15 60 5.6 3.5 +25 −15 −10
statistics when we allow the allocation of a maximum weight of 5%, 15%, or 25% to
the photovoltaic investment opportunity.
The “higher return” or “lower risk” portfolios, denoted by “HR X% PV”, and “LR
X% PV,” respectively, are given in the three tables together with the corresponding
expected risk and expected return figures. (X denotes the photovoltaic investment
proportion in the portfolio.) These efficient portfolios (with weights for photovoltaic
(PV), equity (E) and bond (B) investments), compared to the initial allocation, yield
the same expected return with less risk, or the same risk with more expected return.
The last three columns of Tables 3.6–3.8 present the weights differences between the
initial allocations and the new efficient weights, i.e., the substitutional effects due to
the introduction of photovoltaic investments.
The dominance of portfolios including the photovoltaic investment opportunity
is striking. In Table 3.6, we see the results for an initial equity allocation of 10%.
The higher return portfolios show an increase in expected return from 20 bp up to
70 bp depending on the maximum quota of photovoltaic investments in the portfolio.
For example, the higher return portfolio with a limit of 5% in photovoltaics (“HR
5% PV”) allocates the maximum of 5% to photovoltaic investments, 13% to equities
and 82% to bonds, increasing the expected return from 4.9% to 5.1% at the same
level of expected risk (3.5%). The lower risk portfolios (“LR X% PV”) decrease the
expected risk by up to 60 bp (or approximately 17% in relative terms) at the same level
of expected return. With higher photovoltaic limits, the risk and return characteristics
cannot even be brought down to the initial levels when selecting portfolios from the
efficient set. The minimum expected return for “LR 15% PV” is 5.1%, for “LR 25%
PV” it is 25%, respectively.
68 Mader et al.
In Table 3.7 we see higher return and lower risk portfolios for an initial allocation
of 20% in equites. The improvement on the return side ranges from 10 bp to 60 bp and
up to 110 bp (or approximately 27% in relative terms) on the risk side. The comparison
of the optimized portfolios to a 30% equity portfolio in Table 3.8 reveals up to 60 bp
more return and up to 160 bp (or approximately 31% in relative terms) less risk.
Interestingly, the optimized portfolio allocations in the case of the “10% Equity”
and “20% Equity” show a slight increase in the equity weight for the higher return
portfolios, as the photovoltaic investment seems to reduce the portfolio risk substan-
tially. Therefore, the bond allocation is reduced by up to 30% (“HR 25% PV” with
“10% Equity” as initial allocation). For the “30% Equity” portfolio, the optimized
higher return portfolios show a stable allocation in equities — bonds are substituted
for by the allocation to photovoltaic investments. When we optimize the lower risk
portfolios, the allocation to photovoltaic investments consistently substitutes equity
and bonds. For the “20% Equity” portfolio both substituted at similar amounts, for the
“30% Equity” portfolio compared to bonds more equity is substituted, and for “10%
Equity” portfolio more bonds are substituted compared to equity.
3.5. CONCLUSION
Investing in photovoltaic facilities is environmentally supportive. In addition, photo-

voltaic investments are an attractive asset class from an investment perspective. In
our analysis, the maximum weight allowed is allocated in all of our optimized portfo-
lios. We see a straightforward tendency that, including photovoltaic investments in a
portfolio, decreases risk and/or increases expected return.
To derive these results, we make use of a comprehensive framework to analyze
the attractiveness of photovoltaic investments in a multi-asset portfolio. Based on
our bottom-up approach, we are able to identify the quantitative characteristics of
photovoltaic investments in a portfolio context.
We optimized portfolios including photovoltaics with respect to initial allocations
of 10%, 20%, and 30% in equities, respectively. These base allocations reflect different
risk and return preferences of representative investors. Depending on the preferences
and the maximum allowed photovoltaic weight, optimized higher return portfolios
provide increases in expected return of up to 70 bp while the lower risk portfolios
decrease the risk figures by up to 1.6% in absolute or by 31% in relative terms.
As a result, we find that in optimized higher return portfolios photovoltaic invest-
ments substitute bonds — allowing slight increases in the equity quota at the same time.
For the lower risk portfolios, the allocation to photovoltaic investments is financed by
decreasing bond and equity weights at the same time. The reduction of bond and equity
allocations is approximately the same.
The chosen bottom-up framework allows for the inclusion of alternative real assets
when evaluating and optimizing the portfolio allocations. We can examine the port-
folio contribution of alternative real assets in general and we are able to customize
the modeling for specific investment assets in great detail. Beside the analysis in a
portfolio context, this bottom-up modeling also allows ongoing monitoring of specific
alternative real assets.
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THE FREIGHT MARKET

AND ITS DERIVATIVES
4
RÜDIGER KIESEL∗ and PATRICK SCHERER†
∗
Institute of Mathematical Finance, Ulm University,
Helmholzstr. 18, 89081 Ulm, Germany,
and
Centre of Mathematics for Applications,
University of Oslo,
ruediger.kiesel@uni-ulm.de
†
Institute of Mathematical Finance, Ulm University,
Helmholzstr. 18, 89081 Ulm, Germany,
patrick.scherer@uni-ulm.de
Despite the fact that the freight market is one of the oldest markets, it found only limited
attention in financial (mathematics) studies. One possible reason may be that this
market is very intransparent and only active market participants such as shipowners,
dockyards, and commodity traders were fully informed on market activities. With
the launch of freight market derivatives, however, many other financial institutions
started to actively trade on the freight market, for instance by taking positions on future
global trade activities via Forward FreightAgreements and Freight Futures. This article
provides an introduction to the freight market and its most commonly used financial
assets. We investigate the relationship between the freight market, freight derivatives,
and macro-economic variables. Further, we show how these relationships can be used
to better explain and predict the future price movements of freight derivatives. To
achieve this, we propose to use classical statistical methods, such as Vector Auto
71
72 Kiesel and Scherer
Regression and Vector Error Correction Models, to incorporate the information from
spot markets and related explanatory variables into the prediction process.
4.1. INTRODUCTION: THE FREIGHT MARKET
The oversea shipping market has been established in the 17th century and thus is
one of the oldest physical markets. In 2007, the volume of international seaborne trade
reached 8.02 billion tons [1]. In 2008, over 80 per cent of the worlds merchandise trade
volume was carried by sea, making the maritime transport the backbone of international
trade and globalization. Despite its size, it found only limited attention in financial
(mathematics) studies and for a long time it failed to attract the focus of investors
from outside the traditional shipping market environment. Since the shipping market
is exposed to various risks, it is highly volatile. Historically, these risks were mainly
due to unsuitable technical equipment, lack of reliable weather forecasts, piracy, etc.,
which in many cases led to the loss of freight, the ship, and the lives of the crew. While
natural risks are still present nowadays, financial risk for shipowners, commodity
traders, charterers, and other investors and market participants have become more
important.
4.1.1. Vessels
The modern fleet of vessels used for overseas shipping is well diversified. We see a
large range of modern cargo vessels, ranging from small coasters to very large tankers,
but generally we can classify them in terms of the groups given in Table 4.1 below.
Not reported in the table are liquefied natural gas (LNG) tankers, general cargo (Gen
Cargo), and Roll On-Roll Off (Ro-Ro) carriers, as well as vessels that are able to carry
a combination of chemicals and oil products. Furthermore, passenger cruise ships
are excluded in the analysis of this paper. In the 2008 report of the United Nations
Conference on Trade and Development (UNCTAD [1]), it is stated that the world vessel
fleet expanded by 7.2 per cent during 2007 to 1.12 billion deadweight tonnage (DWT)
at the beginning of 2008. Deadweight tonnage is a measure of how much weight of
cargo a ship can carry. Just to give an impression on prices, a 170,000 DWT dry bulk
carrier was priced at $97 million in December 2007 about 39 per cent more than a
year before, and 2.4 times the price paid in 2000. Greece, Japan, and Germany are the
world’s top three shipowning nations.
4.1.2. Cargo
The main cargos of tankers are crude oil products (“dirty oil”) and refined oil products
(“clean oil”), chemicals as well as liquefied natural and propane gas (LNG resp. LPG),
The Freight Market and Its Derivatives 73
Table 4.1 Number of Vessels in Service (IS), on Order (OO), Under

Construction (UC) and Their Combined Capacity Measured in Dead
Weight Tonnage (DWT). Obtained from Bloomberg on 20/2/2009.
Tankers # IS # OO # UC DWT (#000)
Crude oil 2028 521 73 307,497

Oil product 1416 341 79 47,101
LPG 486 101 12 12,684
Chemical 371 164 30 6860
Carriers # IS # OO # UC DWT (#000)
Bulk 6091 2957 235 374,239

Ore 80 87 16 17,240
Vehicle 679 195 44 11,187
Containers # IS # OO # UC DWT (#000)
Container ships 4461 1001 139 161,504
whereas dry cargo such as ore, coal, bauxite, phosphates, cement, scrap, steel, sugar,
grain and rice, cars, containers are shipped via bulk carriers or container ships. Half
of the cargos are energy related while container traffic is just over 10% by weight, but
much higher in terms of value. Ship sizes are measured in DWT and include Capesize
>100,000 DWT, Panamax 60–100,000 DWT (capable to cross the Panama Canal),
Supramax 40–60,000 DWT as well as Handysize 10–40,000 DWT.
4.1.3. Routes
The biggest trading routes by vessel type and size are given in Table 4.2. In our analysis,
we restrict our focus to the three routes given in bold. These are the most frequently
served routes, and we were able to obtain a data set of high quality for them.
TD3 The “Tanker Dirty Route 3” route from Ras Tanura, Saudi Arabia to Chiba,
Japan is the most common trade route into Asia for very large crude carriers.
The standard 260,000 ton of non-heat crude carried from Saudi Arabia to Japan
on TD3 is approximately two million barrels of oil. As spot price (USD/Ton),
we make use of the Bloomberg price series “D27TAGJP Index.”
TC2 Being the freight element of the cross Atlantic gasoline arbitrage trade, the
“Tanker Clean Route 2” route is the most frequently traded clean product tanker
contract. The TC2 route is typically served by modern Panamax or Supramax
tankers carrying clean product (most often gasoline and other light distillates)
from Rotterdam to New York Harbor. For spot prices, we use the Baltic Clean
Table 4.2 Most Common Routes.

Dirty tanker Main cargo
TD3 Ras Tanura, Saudi Arabia to Chiba, Japan Crude oil

TD5 West Africa to US coast
TD7 North sea to Continent
TD8 Kuwait to Singapore
TD9 Caribbean to US Gulf
TD11 CrossMed
TD17 Baltic to UK/Continent
Clean tanker
TC2 Rotterdam to New York Clean oil

TC4 Singapore–Japan
TC5 AG–Japan
TC6 CrossMed
Capesize
C3 Tubaro to Beilun
C4 Richards Bay, South Africa to Rotterdam Coil
C5 Western OZ to Beilun
C7 Puerto Bolivar (Ecuador) to Rotterdam
Panamax
P2A Mediterranean to Far East

P3A Japan to South Korea
Tanker Index “BITY Index,” which is an average over all clean tanker routes for
the year 2005, and the “CMRTUKUA Index” for the remaining time, because
its price history starts in 2006 and all other prices are available from 2005.
C4 The most common dry cargo routes are the big coal and iron ore transportation
routes from Africa to Europe and from South America and Australia to Asian
destinations. We consider the “Capesize Route 4” route from Richards Bay,
South Africa to Rotterdam with spot prices represented by the SSY price history
“SSYWRBRT Index.”
4.2. FREIGHT RATES: WHAT DRIVES THE MARKET?
As it can be seen from the spot prices of the three routes given in Fig. 4.1, volatility is
high in the freight market. Typically, the price of shipping one ton of cargo on one of
TD3 freight rates

60
40
20
0
2005 2006 2007 2008 2009
TC2 freight rates
60
40
20
0
2005 2006 2007 2008 2009
C4 freight rates
60
40
20
0
2005 2006 2007 2008 2009
Figure 4.1 Spot price histories in USD/Ton for the period 01/01/2005 to 20/2/2009.
the three routes trades between 15 and 35 USD, but strong deviations from this band
have occurred even before 2008. We further observe that the freight market experi-
enced many pronounced cycles of high as well as low rates. Also the financial crisis
of 2008/2009 had its effects on the freight market; in line with the stock markets, rates
dropped in late 2008 and remained at a low level until spring 2009 when they slightly
recovered. The effects of the credit crunch on the freight rates as well as on the entire
shipping industry is further discussed in [2]. The authors note that the economic slow-
down affected the shipping market more than most other markets, for example causing
an 94% drop of the Baltic Exchange Dry Index from May to December 2008. The con-
sequences of this variability are twofold: the typical market participants are in need
of hedging instruments to lay off some of the risk of adverse price movements, while
new investors and speculators are drawn to the market because large price movements
can imply large profits.
In order to understand this high variability of the freight rates, we first have to
identify the price drivers of the market, i.e., what variables govern the demand and the
supply of freight capacity, and therefore the freight rates.
4.2.1. Demand for Shipping Capacity

We expect the demand for shipping capacity to be positively correlated with the indus-
trial performance and activities in the country of origin as well as destination. Looking
at the typical cargos (oil products, chemicals, gas, ore, coal, bauxite, phosphates,
cement, scrap, steel, sugar, grain, rice), we expect this relationship to be rather strong.
What is the level of industrial production? Has the grain harvest been successful? Are
power stations importing more coal? How is the steel industry performing? Commodity
demand directly implies demand of shipping capacity. Stock indices and futures on
indices can be seen as a proxy for the physical industrial activities. Futures have the
additional feature of a time horizon for which expectations of the underlying prices
are captured. Further, we include various commodity prices as well as prices of fuel
and energy products.
Due to the globalization, many goods and commodities are imported from over-
seas. This is beneficial as a basic principal from economic theory, but additionally on
a short-to-medium horizon, exchange rates further influence the benefit. Thus, in the
analysis below we include the main FX rates as explanatory variables.
Note that the demand of shipping capacity can change rapidly. Extreme economi-
cal or environmental events, even exceptional weather conditions, can imply significant
and fast changes in the need of energy, building materials, goods, and thus of shipping
capacity.
4.2.2. Supply of Shipping Capacity

In contrast to the potentially fast-changing demand, adjusting the supply side can only
be done gradually. In the short term, supply can be shortened by changing the speed
of the vessels, or by not operating them at all. Long-term adjustments can be made by
ordering/building more or fewer ships, or by moving the scrapping day of old vessels
forward.
With historical high demand for shipping capacity lasting until late 2008, the
shipping industry responded by ordering new tonnage which led to a constant increase
of shipping capacity over the last decades. For example, the order book of crude oil
tankers reached its all-times high in late 2008 with a size of 576 vessels. The drop in
the order book down to 521 in February 2009 seems relatively small.
With the Chinese expansion plans (e.g., found in [3]) in our minds, it seems clear
that supply will continue to increase over the next years. In 2010, however, due to
new environmental regulations, many single hull tankers will have to be scrapped, or
transformed to double hull tankers or bulk carriers which will shorten the likely surplus
of tanker capacity in that period.
In the analysis below, we take fleet supply into account by including tanker as
well as bulk carrier DWT histories into the analysis.
4.2.3. Costs
The main components of a vessel’s costs are typically divided into voyage costs and
daily running costs and may include, among other factors, crew wages, overtime, pen-
sion contributions, insurance, traveling costs, victualing, insurance, deck and engine
room stores and spares, lubricating oil, periodic costs such as dry-docking, special
surveys, running repairs, office and/or management costs, port disbursement, canal
dues, commissions, taxes, etc. The main component, however, are bunker prices. With
bunker fuel accounting for between one-quarter and one-third of the cost of running a
vessel, oil price movements directly affect shipowners.
We further include interest rate products in the analysis below because the costs
of financing ships, financing freight for the duration of the journey, etc. are likely to
affect freight rates.
4.3. FREIGHT DERIVATIVES: HEDGING OR SPECULATING?
A freight derivative is a financial contract which sets an agreed future price for car-
rying commodities at sea. Freight derivatives were introduced to give freight market
participants an instrument to reduce their various risks. Given the current volatility of
the freight markets, managing freight market risk is a significant issue for the shipping
industry. For example, by locking in deals well in advance, shipping companies as
well as commodity traders achieve to be less exposed to spontaneous adverse price
movements on the spot markets.
The first contracts in this respect were time charter agreements. Here, the vessel
is chartered to a counter party over a certain time span, typically a few years. We now
see efforts to open the market to more participants, making it possible to trade not only
cash settled (the supertanker “AbQaiq” will not show up at your front door), but also
in standard contracts traded on an exchange and without counter party risk.
The two main institutions in the field are the Baltic Exchange in London [4] as well
as Imarex in Oslo [5], both providing further information on trading freight derivatvies
as well as background reports.
4.3.1. Forward Freight Agreement

One type of modern freight derivatives are the so-called forward freight agreements
(FFAs). These contracts are traded “over the counter” on a principal-to-principal basis.
As such, they can be designed very flexible to fit the needs of the two contractual parties.
But as a consequence, the FFAs will not be comparable and thus are not traded on any
exchange.
To obtain more standardized products, the contract details can be based on the
terms and conditions of the Forward Freight Agreement Brokers Association [6]. The
main terms of an agreement cover the following specifications:
• Contract route: the agreed physical trading route.
• Contract period: the period for which the prices are fixed.
• Contract quantity (Q): the amount of the cargo for which prices are fixed.
• Contract rate (CR): the rate at which differences will be settled.
• Settlement rate (SR): calculated as the average spot price during the contract period.
On settlement, typically within five days after the contract period, the two parties will
settle the contract according to the following simple calculation: the seller of the FFA
contract is required to pay the buyer an amount equal to (CR − SR) · Q.
Again, due to the inhomogeneity of the freight market, there is no spot price readily
available. Instead, daily freight rate assessments of the physical routes are provided by
independent organizations such as the Baltic Exchange. Their daily route assessments
are based on input from participating ship brokers according to fixtures concluded on
the day and market sentiment. Baltic spot rates aim to be “Fair Value” assessments of
the market on any day.
4.3.2. Freight Futures

In order to allow for clearing and to make it possible for an even broader clientele to
trade in freight derivatives, freight futures were introduced. In contrast to the FFAs
above, these contracts are always marked-to-market on a daily basis. Again, these
are cash-settled contracts with no physical delivery and the settlement is against the
average spot price in the delivery period. The biggest exchange for these contracts is
the International Maritime Exchange [5].
The disadvantage of the futures contracts is that a perfect hedge might not be
possible. Since only main routes are traded with these standardized contracts, there
might not be futures for an actually serviced route, and instead a position may, e.g.,
only be hedged with an available future on a route basket.
In our analysis, we include the monthly future prices for the three routes chosen
in Sec. 4.1. These are provided by Imarex and we obtained them via Bloomberg. The
names and Bloomberg tickers are reported in Table 4.3. The actual underlying spot
prices of these futures are the Baltic Exchange Route Assessments, but access to these
is only granted to subscribers of their service. Thus, we use the spot prices that we
could obtain through the Bloomberg service. After comparing these spot prices with
Table 4.3 Route Spots and Futures.
TD3 Bloomberg ticker
Spot D27TAGJP index

Front month IFTD3TBM index
Front month+1 IFTD3T1M index
Front Month+2 IFTD3T2M index
TC2 Bloomberg ticker
Spot 2005 BITY index

Spot 2006-current CMRTUKUA index
Front month IFTC2TBM index
Front month+1 IFTC2T1M index
Front month+2 IFTC2T2M index
C4 Bloomberg ticker
Spot SSYWRBRT index

Front month IFFDC4BM index
Front month+1 IFFDC41M index
Front month+2 IFFDC42M index
the front month contract and carefully reading the product specifications of our “spot”
prices, we believe to have a good proxy for freight spot prices at hand.
4.4. EXPLANATORY VARIABLES
We now try to identify explanatory variables for the observed price movements in
freight spot and freight futures rates. Instead of manually setting up an economic
model for the relations between variables, we extract the information by means of
standard statistical Vector Auto Regression (VAR) and Vector Error Correction Models
(VECM).
As potential explanatory variables for the spot and future prices of our three routes,
we take variables from the groups identified in Sec. 4.2. In more detail, these are
reported in Tables 4.4 and 4.5. We consider the indices and futures as forward looking
indicators of economic activity. The exchange rates are motivated by the geographic
location of the main routes (linking Europe, Africa, Japan, and the United States) and
Table 4.4 Potential Explanatory Variables and Bloomberg Tickers I.
Stock index, futures (Index) (Index)
Dow Jones industrial INDU GCC 200 (Africa) BGCC200

FTSE 100 (UK) UKX Future Dow Jones DJH9
DAX (Germany) DAX Future FTSE 100 Z H9
EURO STOXX 50 SX5E Future DAX GXH9
Nikkei 225 (Japan) NKY Future EuroSTOXX VGH9
S&P ASX (Australia) AS51 Hedge Fund Index HFRXGLE
Shipping market (Index) (Index)
Baltic Panamax BPIY Tanker DWT VESLCODW

Baltic Capesize BCIY Bulk Carrier DWT VESLBKUC
Baltic Handymax BHSI Conainership DWT VESLCTDW
Baltic Clean Tanker BITY Baltic Dry Index BDIY
Baltic Dirty Tanker BIDY Baltic Supramax BSI
FX (Curncy) (Curncy)
EUR vs. USD EUR JPN vs. USD JPY

GP vs. USD GBP South Africa vs. USD ZAR
Commodities (Index) (Comdty)
Gold GCM9 CRB Commodity CRB RIND

Silver SIK9 CRB Metal Index CRB METL
Copper LPK9 GSCI SPGCCI
Lead LLK9 GSCI Energy SPGCEN
Aluminum LAK9 GSCI Indust. Mtl SPGCIN
Zinc LXK9 Nickel LNK9
the commodities are part of the freight. We expect that the fuel- and energy-related
commodities are particularly helpful since their prices are closely monitored economic
variables and their dependence on economic activity is high.
4.4.1. Explanatory Power

Vector Auto Regression (VAR) models extend the traditional univariate autoregres-
sion model to a vector of time series which jointly evolve through time. Besides
autocorrelation, the model allows for cross-correlations, thus allowing interaction
between the two time series. To assess the actual explanatory power of the poten-
tial explanatory variables listed above, we estimate a VAR for the bivariate log returns
series of the freight rates and each variable.
Table 4.5 Potential Explanatory Variables and Bloomberg Tickers II.
Energy (Comdty) (Index)
Brent crude COM9 Oil Spot UK EUCRBRDT

Gas oil QSK9 Oil Spot USA USCRWTIC
RBOB gasoline XBK9 Oil Spot Arab. Gulf PGCRDUBA
Crude oil CLK9 Oil Spot Asia APCRTAPI
Natural gas NGK9 Coil Rotterdam 1M API21MON
Heating oil HOK9 Coil Rotterdam 2M API22MON
Oil USA 1M CL1 Coil Rotterdam 3M API23MON
Oil USA 2M CL2 Coil Rotterdam 4M API24MON
Oil USA 3M CL3 Coil Richard’s Bay 1M API41MON
Int. rate products (Index) (Index)
LIBOR USD 1M US0001M LIBOR JPY 6M JY0006M

LIBOR USD 3M US0003M LIBOR GBP 1M BP0001M
LIBOR USD 6M US0006M LIBOR GBP 3M BP0003M
LIBOR JPY 1M JY0001M LIBOR GBP 6M BP0006M
LIBOR JPY 3M JY0003M
We introduce the following notation: since it will be clear from the context if spots
or futures prices are considered, both the freight spot and freight futures time series
are named F = (Ft ), and by ft = log(Ft+1 /Ft ) we refer to their log returns. Similarly,
by et = log(Et+1 /Et ), we refer to the log return series of the explanatory variable
E = (Et ) under consideration.
We work with the following specification of the VAR model.
 
20 20
 µ + aj ft−j + bj et−j 

 f  f
ft  j=1 j=1  t
=  + (4.1)
et  20 20  et
µ + ce + df 
e j t−j j t−j
j=1 j=1
with an N0, distributed white noise error term , and all coefficients being real
numbers.
Thus, in the model framework used here, we assume that log returns of freight
rates and explanatory variables are given by a constant (µf resp. µe ) plus a weighted
sum of lagged “old” log returns, plus an error term which for simplicity we assume to
be normally distributed.
We use 20 lags because working with daily data, this number corresponds to
one month worth of data. It is desirable to include even more lags, to capture rela-
tions which hold over several months, but we found this yields unreliable, unsta-
ble results in most cases and thus we do not increase the maximal lag sizes at the
moment.
One application of the VAR model is that it allows for a Granger Causality test.
4.4.2. Granger Causality

A time series e is said to Granger Cause another time series f if the present values of f
can be predicted more accurately by using past values of e than by not doing so, see [7].
In terms of the Vector Autoregression model above, the explanatory variables under
consideration Granger Cause the freight rates under consideration (spot or futures) if
some of the bj coefficients are significantly nonzero.
Standard regression theory can be applied for a test of the joint null hypothesis
that all of the bj values appearing in Eq. (4.1) jointly equal zero vs. the alternative that
at least one does not equal zero. For the test statistics, one calibrates the full and the
reduced model (i.e., setting all bj = 0) and compares sums of squared residuals to
assess the gain of explanatory power from including the bj variables.
The test statistic is
(T − 2) · (l − 1) RSSRed − RSSFull
GCRT = · ,
l RSSFull
and is compared to a quantile of the F(l, (T − 2) · (l − 1)) distribution. Here T stands
for the number of observation days, and l stands for the number of lags, e.g., l = 20
for one month of daily data in our specification.
The sums of squared residuals SSRFull and SSRRed are defined by SSRFull =
T f
t=1 t with residuals from the full model in Eq. (4.1), and similarly SSRRed is the
sum of squared residuals in the reduced model with bj = 0 for all j. For each of the 71
explanatory variables, we calculate the P-Value for the Granger Causality test between
the explanatory variable’s log return series and the log return series of the route’s spot
and futures prices.
In Table 4.6, we report the top 15 resulting values and five further values that are
of interest because of the economic relation between the explanatory variable and the
route.
Before moving on, let us do a quick plausibility check of the results obtained
thus far.
TD3 The tankers of this route carry crude oil from Saudi Arabia to Japan. Indeed, as
expected the spot prices of oil, priced in Saudi Arabia and Japan, can also be
found on the list, as well as the Nikkei 225, the major stock index for Japan.
Table 4.6 Granger Causality Test Results. For Each of the Three Routes We Report
the 15 Most Significant Causality Test P-Values, Averaged over FFA Spot and Futures.
TD3 TC2 C4
0.00 Dirty Tanker Ind. 0.00 Clean Tanker Ind. 0.00 Baltic Dry Ind.
0.02 LIBOR USD 1M 0.01 LIBOR USD 1M 0.00 Capesize Index
0.04 Oil Spot Arab. Gulf 0.01 FX EUR vs. USD 0.02 Dow Jones Indust.
0.05 Natural Gas 0.05 GSCI Energy 0.09 CRB Metal Index
0.07 Oil Spot UK 0.05 Dirty Tanker Ind. 0.10 CRB Comm. Index
0.09 Clean Tanker Ind. 0.07 GSCI 0.10 DAX
0.09 GSCI Energy 0.07 Oil Spot USA 0.12 FTSE 100
0.10 Crude Oil 0.07 Oil Future USA 2M 0.15 Oil Spot Asia
0.11 Oil Future USA 1M 0.09 CRB Comm. Ind. 0.15 EURO STOXX 50
0.11 Oil Future USA 4M 0.09 Natural Gas 0.19 S&P ASX Index
0.11 Oil Spot Asia 0.09 FX GP vs. USD 0.21 Oil Future USA 6M
0.12 Oil Future USA 2M 0.10 Oil Future USA 3M 0.21 Oil Future USA 3M
0.12 FX GP vs. USD 0.10 Oil Future USA 1M 0.21 Coil Rotterdam 2M
0.13 Oil Future USA 3M 0.11 Oil Future USA 5M 0.22 Crude Oil
0.14 Brent Crude 0.11 Oil Spot Asia 0.23 Aluminum
0.19 Nikkei 225 0.14 Oil Spot UK 0.25 Oil Future USA 2M
0.19 Oil Spot USA 0.46 Tanker DWT 0.26 Coil Rotterdam 1M
0.43 Dow Jones Indust. 0.49 Dow Jones Indust. 0.29 Coil Rich. Bay 2M
0.45 FX JPN vs USD 0.50 EURO STOXX 50 0.30 Coil Rotterdam 3M
0.58 Tanker DWT 0.55 DAX 0.65 Bulk Carrier DWT
Further, both the clean and dirty tanker indices from the Baltic Exchange rank
among the top variables.
TC2 This route’s vessels take oil products from Rotterdam to the United States. Again,
oil-related variables are on the list of the top 15 related variables, together with
exchange rates and oil futures prices.
C4 The capesize bulk carries of the C4 route mainly carry coil from Richards Bay,
South Africa to Rotterdam. Besides the energy related-variables, the metal and
commodity indices from CRB as well as the Coil Prices are among the top 15
out of the total 71 variables.
4.4.3. Selection Algorithm “Top Five”

In what follows, we attempt to improve the prediction of future freight prices, using
information available today. To keep things simple, we restrict ourselves to just using
five of the above variables. Instead of simply using the top five of Table 4.6, we
extend the bivariate model from Eq. (4.1) to a multivariate model and take those five
variables that minimize the sum of squared residuals of the freight rate log return
series. The reason for this additional selection algorithm is that five carefully selected
variables typically have a higher combined explanatory power than the five top individ-
ual explanatory variables. For example the Baltic Dry Index is very similar to the Baltic
Capesize Index, and therefore will not deliver substantial additional information.
Instead of trying out all 71 · 70 · 69 · 68 · 67 combinations of explanatory variables,
we apply a Greedy scheme which subsequently adds the variable that minimizes the
sum SSRFull in the two, three, four and five dimensional model.
The resulting top variables for the spot and first month contracts are given in
Table 4.7, where we applied the procedure on the entire data set. It is interesting to
see that besides the variables with the obvious relations other variables have a high
explanatory power as well, for example the LIBOR rates.
4.4.4. Cointegration
Another concept of dependence between two or more time series is that of cointegra-
tion. In the bivariate case, we say that two time series f and e are cointegrated if each
of the series itself is integrated of order one, while some nontrivial linear combination
(f, e) · a of the two series is stationary. a is then called cointegration vector. The
interest in cointegration theory among the economists is due to the fact that it allows
to model stable long-term relations in between non-stationary variables. We can use
cointegration analysis in three ways:
• Find an equilibrium relation in a system of price series.
Table 4.7 Top Five Selected Variables Through the Greedy Scheme for
the Entire Data Set. The First Set of the Five Variables Corresponds to
FFA Spot Prices and the Second Set to Front Month FFA Futures Prices.
TD3 TC2 C4
Top 1 Dirty Tanker Ind. Clean Tanker Ind. Baltic Dry Index
Top 2 Natural Gas LIBOR USD 1M LIBOR JPY 1M
Top 3 FX EUR vs. USD LIBOR JPY 3M Gas Oil
Top 4 LIBOR USD 1M FX EUR vs. USD Dow Jones Indust.
Top 5 LIBOR JPY 1M Copper GCC 200 (Africa)
Top 1 Clean Tanker Ind. Clean Tanker Ind. Capesize Index

Top 2 LIBOR JPY 1M Oil Spot Asia LIBOR GBP 3M
Top 3 Dirty Tanker Ind. Oil Spot Arab. Gulf Dow Jones Indust.
Top 4 LIBOR USD 1M LIBOR USD 1M GCC 200 (Africa)
Top 5 Nikkei 225 Oil Spot UK LIBOR USD 1M
• Estimation of future prices can be improved. If the cointegration vector is known or

estimated and the equilibrium relation is violated, then a move of the series back to
the equilibrium is more likely.
• There must exist causality in at least one direction when two series are cointegrated
[7], i.e., at least one variable is helpful in predicting another.
The models used in this context are of the following form, where F and Ei , i =
1, . . . , 5 denote the freight and explanatory variables respectively, denotes first
order difference. Let yt be given by
yt = (log(Ft ), log(Et1 ), log(Et2 ), log(Et3 ), log(Et4 ), log(Et5 )) ,
then the Vector Error Correction Model (VECM) is given by the following represen-
tation:

20
yt = µ + j · yt−j + · yt−1 + t .
j=1
Thus, in this framework, we model the FFA log returns (which equal the first differ-
ences of log prices) to be given by the following composition: a constant µf , given by
the first entry of the real vector µ, plus a weighted sum of lagged log returns of the
FFA series and the lagged log returns of the explanatory variables. The weights of the
sum corresponding to the j -lagged log returns are given by the first row of the real–
matrix j . The third summand is given by the first entry of the matrix–vector product of
the cointegration matrix with the lagged log price series. The rows of the cointegra-
tion matrix describe the cointegration relations and the rank of the matrix corresponds
to the number of cointegration relationships. The last summand is given by the first
entry of a six-dimensional white noise error term , which we again assume to be
normally distributed. The explanatory variables are modeled using the same principle.
For the estimation of the models we utilize the R package “URCA” by Bernhard
Pfaff, where we find a fast estimation procedure based on the seminal papers by
Johansen in [8]– [10]. Further tests in the VECM framework are implemented as well.
These are typically employed to estimate the cointegration rank and to test if the
cointegration vector equals a certain exogeneously given vector, all of which we do
not need for our application of the model. The tests are rather involved and the test
statistics depend either on the rank or eigenvalues of the cointegration matrix or
on the residual vector . However, we checked on the rank and always found at least
one cointegration relation with the “top five” variables obtained through the selection
algorithm above which suffices for our task.
As an illustrative example, we find the cointegration relationship between the
logarithms of spot prices of the tanker route TD3 and five explanatory variables. In
order to be able to check the results, we manually selected five explanatory variables,
based on obvious economic relations in between the variables. In this example, we

consider
F TD3 Spot
E1 Dow Jones Industrial
E2 EURO STOXX 50
E3 Exchange Rate EUR vs. USD
E4 Oil Spot Price UK
E5 Oil Spot Price USA
Applying the cointegration procedures, we estimate the cointegration vec-
tor to be a = (1, −0.38, 0.33, 0.07, 8.33, −9.49) , i.e., the linear combination
(F, E1 , E2 , E3 , E4 , E5 ) · a is trend stationary.
A possible economic interpretation of this relation can be given as follows: let us
look at E1 and E2 only. If the European economy is slowing down compared to the
American economy, it follows that −0.38 · log(E1 ) + 0.33 · log(E2 ) will decrease. As
a consequence, to keep the above relation trend stationary, the FFA spot price has to
increase, which is likely to happen in this example, since more oil is asked for in the
United States than in Europe, and thus fright prices rise. A similar interpretation can be
given for E4 and E5 . If, for whatever reason, spot prices in Europe fall compared to spot
prices in the United States, then 8.33 · log(E4 ) − 9.49 · log(E5 ) will decrease, forcing
the FFA rate to increase, to keep the total sum trend stationary. Again, this is likely to
happen since it is more profitable to ship oil to New York, where higher prices are paid.
4.5. PREDICTING FREIGHT SPOT AND FUTURES RATES
We have made two models available and we will see in this section that both allow for
out of sample predictions of future prices. The extension of the VECM over the VAR
is the additional balance term which models the cointegration relationship. Since we
work with log returns in the VAR model and apply the VECM with its first differences
to log prices, the two models become well comparable. For a given calibration day T ,
we apply the following procedure to draw out of sample forecasts of freight spot and
freight futures prices F over the period [T, T + τ]. In the following, we set τ = 100,
and therefore make forecasts for the next 100 working days.
1. Preparation: prepare the historical data used for the estimation: for the freight rate
F under consideration and the potential explanatory variables:
1.1 Specify the estimation window [t, T ].
1.2 Exclude the explanatory variables which are too sparse in the estimation
window.
1.3 Fill the minor data gaps using Brownian Bridges.
1.4 Transform the prices to log prices for the VECM model.
1.5 Calculate the log returns for the VAR model.
2. Top Five: out of the remaining pool of cleaned explanatory variables, select the five
variables with the biggest combined explanatory power in the estimation window
via the algorithm explained in Sec. 4.4.3.
3. Estimate models: estimate the parameters of the VAR and VECM model from
Sec. 4.4 in the six-dimensional setup using the data in the estimation window.
4. Draw out of sample forecasts for the period [T, T + τ] and transform these to actual
FFA rates, i.e., transform predicted log returns to prices in the VAR model, and the
forecasted differenced log prices to actual prices in the VECM model.
The predictions occurring in the fourth step above are obtained in the natural way: In
two dimensions, the VAR model is set to the specification:
 
20 20
 µ + aj ft−j + bj et−j 

 f  f
ft  j=1 j=1  t
=  + ,
et  20
20  et
µ + ce + df 
e j t−j j t−j
j=1 j=1
with an N0, distributed error term .

In order to draw an out-of-sample forecast fT +1 , we set the random error term to
zero and increase t in the formula above to get

20
20
f̂T +1 = µf + aj fT +1−j + bj eT +1−j .
j=1 j=1
Further estimated log returns fˆT +2 , . . . , fˆT +τ are then received recursively, treating
the estimated forecasted values needed for the next day forecast as if they were true
log returns.
The step in the VECM model is carried out similarly: The model is given as

20
yt = µ + j · yt−j + · yt−1 + t ,
j=1
and increasing the time by one day as well as setting the random term to its mean
yields the estimate

20
ŷT +1 = µ + j · yT +1−j + · yT .
j=1
90
80
70
60
50
40
30
20
10
Parameter Estimation Window Forecast Period

3/1/2005 100 200 300 400 2/1/2007 6/25/2007
Figure 4.2 Forecast carried out on 2/1/2007 for 100 working days and compared to actual
prices.
That is, in two dimensions only we get for the FFA term

20
20
log F̂T +1 = µf + aj log FT +1−j + bj log ET +1−j
j=1 j=1
+ (1, 1) · log FT + (1, 2) · log ET .
Working with all the uncertainties of the freight market, like its sudden price movements
in spot as well as futures rates, we cannot expect that our forecasts will yield the correct
prices without error. We can however examine if this error is in the range of a very
conservative forecast model.
4.6. THE BACKTESTING ALGORITHM
We examine the forecast error of our model with the following back test. As an error
quantity we define for a τ days ahead prediction carried out on day T the prediction
error PE as following:

F
T +τ − F̂T +τ
PET,τ = ,
FT
i.e., we compare the absolute value of the relative error of actual rates to model implied
predicted rates. Note that PET,0 = 0. For the actual test, we apply an increasing window
with the initial window covering the period from 1/1/2005 to 1/1/2007. Starting with
this window, we forecast 100 working days and then increase the window by one
working day and repeat the forecast. We advocate the use of an increasing window
over the use of a moving window because the length of the data set allows robust
estimations of the model. For the results described below, we used 20 lags. Increasing
the window on a daily basis allows for 550 calibrations until reaching the end of the
time series on 20/2/2009.
As an additional reference, we include a third very conservative forecast model,
where we simply assume that the prices remain constant.
In order to demonstrate the developed methods, we perform the following backtest.
After preparing the data as described above, we run the following algorithm for the
spot and futures rates of the three routes under consideration.
1. Initializing:
1.1. Prepare the data.

1.2. Set the initial window [1, T 0 ] to the period from 1/1/2005 to 1/1/2007.
2. Loop windows:
2.1. In each of the 550 possible steps, increase the window by one working day to
get the new window [1, T i+1 ].
2.2. Estimate the VAR and VECM model parameters using data only available
in the window, and draw forecasts as described in Sec. 4.5 for the next 100
working days beyond T i+1 .
2.3. Calculate and save the prediction error PET i+1 ,τ , for τ = 1, . . . , 100 for the
VAR and VECM model as well as for constant forecasts.
To visualize the results, we average the prediction error PET i ,τ for τ ∈ {1, 2, . . . , 100}
over the 550 out-of-sample forecasts drawn from the VAR and VECM model as well
as the constant forecasts. The resulting Fig. 4.3 shows the relative error for the TD3
spot prices. Starting with PET,0 = 0 for the “0-days”-ahead prediction, it follows the
error of the conservative constant out-of-sample forecast for the first “10-days”-ahead
predictions but then the error increases slightly.
This shows that the models are able to yield stable forecasts over periods as long
as 100 days ahead. Additional benefits of the models over the constant predictions are
for example readily available confidence regions and the possibility to check on trends
rather than just having constant predictions.
TD3 Spot
0.7
const.
0.6 VAR
VECM
0.5
0.4
0.3
0.2
0.1
0
0 10 20 30 40 50 60 70 80 90 100
Figure 4.3 Relative forecast error.
4.7. CONCLUSION
After an introduction to the freight market and its two main derivatives, we examined
the relation of the highly volatile freight rates with explanatory variables. Incorporating
such physical and economical relations in a model is desirable, as it leads to a better
understanding of the freight market and may improve out-of-sample forecasts. We
proposed the use of two statistical methods to jointly model freight rates and related
explanatory variables.
After two very favorable years, the freight market currently suffers from the world
financial crisis. Large investments over the last years have made shipping capacities
available, but freight rates fell to a level which drove many participants out of the
physical market as well as its derivatives. However, with a revival of the world’s
economy, it is likely to see an upturn of the freight market again.
References
[1] UNCTAD (2008). Review of Maritim Transport. (UNCTAD, 2008).

[2] Whittall, C (2009). Shipping out, Risk, March, pp. 52–53.
[3] Stopford, M (2007). Oil tanker market. Technical report, Baltic Freight Derivatives Forum.
[4] http://www.balticexchange.com/. The Baltic Exchange.
[5] http://www.exchange.imarex.com. International Maritime Exchange.
[6] http://www.balticexchange.com/default.asp?action=article&ID=18. FFABA.
[7] Granger (1969). Investigating causal relations by econometric models and cross-spectral
methods, Econometrica, 37, 424–38.
[8] Johansen, S (1988). Statistical analysis of cointegration vectors. Journal of Economic

Dynamics and Control, pp. 231–254.
[9] Johansen, S (1991). Estimation and hypothesis testing of cointegration vectors in gaussian
vector autoregressive models, Econometrica, pp. 1551–1580.
[10] Johansen, S. Juselius, K (1990). Maximum likelihood estimation and inference on coin-
tegration with applications to the demand for money, Oxford Bulletin of Economics and
Statistics, pp. 169–210.

ON FORWARD PRICE MODELING

IN POWER MARKETS
5
FRED ESPEN BENTH
Centre of Mathematics for Applications, University of Oslo,
P.O. Box 1053, Blindern, 0316 Oslo, Norway
and
University of Agder, School of Management,
Serviceboks 422, 4604 Kristiansand, Norway
fredb@math.uio.no
Power forward contracts deliver electricity over a specified period, and can be viewed
as a portfolio of forwards with maturity at each time instant in the delivery period. We
investigate the implied power forward dynamics from a geometric Brownian motion
specification of the forward price, which turns out to have a very complicated struc-
ture. Lognormal approximations are argued for, and we demonstrate that they work
excellently in many situations. In particular, we focus on the approximation suggested
by Bjerksund et al. [8], where the volatility of the power forward is simply the aver-
age of the fixed-maturity forward volatility. Although giving a superior model to the
moment matched dynamics, it fails to estimate the tails of the power forward distribu-
tion in some cases with extreme volatility and mean-reversion. We provide analytical
bounds in terms of geometric Brownian motions for the power forward dynamics, and
also compare the covariance structure with those implied by a geometric Brownian
motion.
93
94 Benth
5.1. INTRODUCTION
The power markets have in the recent two decades been liberalized in Europe, America,
Asia, and Australia. This freeing of trade in power is a process still going on, and
gradually attracting investors not having any physical interest in power production or
consumption. Large investors like investment banks, hedge funds, and pension funds
see opportunities for portfolio diversification and speculation with this new asset class.
The power markets are naturally divided into spot and forward products, where the
former are usually linked to physical production and consumption, while the latter are
financial.
Naturally, investors without physical capacity are interested in the forward markets
for power. We shall concentrate on the markets for electricity, however, coal, gas, and
oil are also an integrated part of the power market being important fuels for power
production. Taking the Nordic market for electricity, NordPool, as an example, the
power forward contracts are financially settled against the system price in the market.
The system price is the “spot” of this market, an auction-based hourly price for next-
day delivery of electricity. The forward contracts are both of futures and forward type,
and deliver the money-equivalent to receiving the spot over a pre-determined delivery
period. Typically, the delivery period can be a week, month, quarter or year ahead, and
the forward price is given in terms of Euro/MWh.
In this paper, we will be concerned with the analysis of models for the forward
price dynamics. The basis for our studies is taken from Benth and Koekebakker [4],
Bjerksund et al. [8] and Kiesel et al. [17] (see also Benth et al. [6]), where the Heath–
Jarrow–Morton (HJM) technique taken from fixed-income theory is applied to the
power forward market. The main obstacle in using the HJM approach to power markets
is the fact that the forward contracts do not deliver the underlying spot at a fixed
maturity time in the future, but over a delivery period. This creates difficulties in stating
reasonable models, which are analytically and empirically tractable. The standard
approach is to suppose a dynamics for a (non-existing) fixed maturity contract, and
derive the power forward price by averaging over the delivery period. We investigate the
properties of such models and approximations, to understand the stochastic dynamics
of power forward prices.
The motivation for analyzing the price dynamics of power forwards is twofold.
First, by investing in such power products one is naturally interested in the risk asso-
ciated with the strategy chosen. To get hold of this, a proper understanding of the
stochastics of the dynamical behavior of prices is required. This entails in an analysis
of the volatility of the price. Secondly, there are markets for options on power forwards,
both organized and OTC. The arbitrage-free prices of such options are naturally con-
nected to the volatility of the underlying forward as well.
On Forward Price Modeling in Power Markets 95
Our analysis and results are presented as follows: In the next section, we describe
the HJM approach to power forwards, recalling some existing results from Benth
et al. [6]. In Sec. 5.3, we discuss the stochastic dynamics of power forwards, and link
it to approximative geometric Brownian motion processes. In particular, we study the
Bjerksund, Rasmussen, and Stensland approximation to the power forward dynamics,
discuss the covariance structure of power forwards with different delivery periods
and their distributional properties. Several empirical examples are studied. Option
pricing is the topic in Sec. 5.4, where we compare the approximation by Bjerksund,
Rasmussen, and Stensland with the true prices, both for plain vanilla call options and
calendar spreads. We conclude in the final section.
5.2. HJM APPROACH TO POWER FORWARD PRICING
Suppose St is the spot price of power at time t, being a stochastic process defined
on some filtered probability space (, F, F, Q) with time t running in the finite time
interval [0, Tmax ]. We assume that the filtration F satisfies the usual conditions (see
page 10 in Karatzas and Shreve [16]), and supports a Wiener process W = {Wt }t≥0 .
Throughout the paper, we work exclusively under a risk–neutral probability Q.
A long position entered at time t in a power forward contract settled continuously
against the spot price over a period [T1 , T2 ] will yield a profit/loss
T2
e−r(u−t) (Su − Ft (T1 , T2 ))du. (5.1)
T1
Here, t ≤ T1 , and Ft (T1 , T2 ) is the forward price at time t which is denoted in

Euro/MWh. Furthermore, r is the risk-free interest rate, and the expression (5.1) mea-
sures the time t value of the profit/loss. The integration over the delivery period is for
convenience. In the real market, there is a summation over hourly prices instead.
Solving expression (5.1) for Ft (T1 , T2 ), we define the forward price as
T2
Ft (T1 , T2 ) = E w(u, T1 , T2 )Su du | Ft (5.2)
T1
with
re−ru
w(u, T1 , T2 ) = . (5.3)
e−rT1 − e−rT2
If the forward is settled at the end of the delivery period T2 , we use w(u, T1 , T2 ) =
1/(T2 − T1 ) instead (see Sec. 4.1 in Benth et al. [6] for details). Obviously, we
implicitly assume that w(u, T1 , T2 )Su is integrable with respect to Q × du on
× [T1 , T2 ].
96 Benth
By commuting the integration and expectation in (5.2), we obtain

T2
Ft (T1 , T2 ) = w(u, T1 , T2 )ft (u)du, (5.4)
T1
since by definition the forward price of a contract maturing at time u is

ft (u) = E[Su | Ft ].
We note that there are no power forward contracts with fixed maturity time, thus, ft (u)
exists only in a mathematical sense. However, the relation (5.4) shows us that a power
forward contract may be considered as the weighted average of “standard” forward
contracts, where the averaging goes over the delivery times. Alternatively, holding a
power forward is equivalent to holding a portfolio of forward contracts delivering at
each time in the delivery period.
Since we are going to focus on the HJM approach, the spot price process Su will
not play any role further in this paper. The idea of the HJM modeling perspective in
fixed-income theory is to state an arbitrage-free dynamics of the forward rate process
for all maturities. Taking this approach to commodities, one models the forward price
dynamics for all maturities u (see Chapter 8 in Clewlow and Strickland [9], say). In
the context of power markets, this would entail in modeling the price dynamics of
the non-existing contracts ft (u) for all maturities u. On the other hand, one may ask
for dynamical models of Ft (T1 , T2 ) for all delivery periods [T1 , T2 ]. However, as it is
shown in Benth and Koekebakker [4], we are ensured an arbitrage-free model as long as
T2
Ft (T1 , T2 ) = w(u, T1 , T2 )Ft (u, u)du, (5.5)
T1
for all 0 ≤ T1 < T2 . This leads us back to a model for Ft (u, u), which is equivalent to
a forward price for a contract with fixed maturity time u. Hence, from this view, it is
natural to use the HJM approach to state models for ft (u), and next derive the power
forward price Ft (T1 , T2 ) from the relation (5.4). In this paper, we shall investigate the
dynamics of the resulting power forward price, and investigate approximations of it in
view of option pricing.
Since ft (u) has to be a martingale, the dynamics will have the form
dft (u) = σ̃t (u)dWt ,
where t → σ̃t (u) is a stochastic process on [0, u] which is supposed to be integrable
with respect to W . The model is defined for general choices of maturity times u, with
the only restriction that u ≤ Tmax . To simplify matters, we shall concentrate on a
geometric Brownian motion structure, and assume that
dft (u) = σt (u)ft (u)dWt . (5.6)
Here, we let σt (u) be a deterministic volatility function with 0 ≤ t ≤ u ≤ Tmax ,
and t → σt (u) is square-integrable on [0, u] for every u ≤ Tmax . We have a model
specifying the full behavior of the forward curve dynamics driven by a single Brownian
motion Wt . We remark in passing that there is no difficulty in assuming a multi-factor
model, but to stay focused we refrain from doing so.
Note that the volatility σt (u) depends on the maturity time u. This allows us to
incorporate the Samuelson effect into the model. The Samuelson effect tells us that the
volatility of the forward price converges to the spot volatility as time to maturity tends
to zero. This effect is heavily based on a mean-reverting property of the underlying
spot price dynamics. In fact, assume that the (risk–neutral) spot price follows the
exponential of an Ornstein–Uhlenbeck process Xt ,
dXt = α(µ − Xt )dt + σdWt ,
with α, σ, and µ being constants, and α, σ > 0. Then, we easily derive that
dft (u) = σe−α(u−t) ft (u)dWt .
Thus, σt (u) = σ exp(−α(u − t)), and letting u − t → 0, we find that the forward
volatility tends to σ at an exponential speed given in terms of the mean–reversion
coefficient α. There is both economical and empirical evidence for an explicit depen-
dence on the maturity time in the volatility function (see Geman [13] and Eydeland and
Wolynieck [10]). Other specifications of a term structure of volatility σt (u) for energy
and commodity markets have been suggested (see Clewlow and Strickland [9]). For
instance, since forwards in the long end of the curve indeed show price volatility con-
trary to the mean–reversion model discussed above, it has been suggested that the
volatility looks like
σt (u) = σ0 + σ1 e−α(u−t) , (5.7)
for two positive constants σ0 and σ1 . The first term σ0 is coming from a non-stationary
factor in the spot prices, like for instance a non-stationary long-term stochastic mean.
One may also introduce seasonality in the volatility term structure. See Benth and
Koekebakker [4] for a discussion of the various models with references to related
work. The volatility model in (5.7) will be our choice in many examples to follow, and
serve as a canonical choice of volatility in power markets.
The degenerate case when σt (u) = σt gives an explicit geometric Brownian motion
dynamics for Ft (T1 , T2 ). Since in that case
t
1 t 2
ft (u) = f0 (u) exp − σs ds + σs dWs
2 0 0
we find
T2 t
1 t 2
Ft (T1 , T2 ) = w(u, T1 , T2 )f0 (u)du exp − σ ds + σs dWs
T1 2 0 s 0
t
1 t 2
= F0 (T1 , T2 ) exp − σ ds + σs dWs .
2 0 s 0
98 Benth
Hence, we have
dFt (T1 , T2 ) = σt Ft (T1 , T2 )dWt . (5.8)
When σt (u) explicitly depends on u, the simple geometric Brownian motion structure
is no longer true.
Before we proceed with analyzing the dynamics of Ft (T1 , T2 ), let us discuss how
one could infer estimates on the parameters of ft (u) when data for such contracts are
not available. One frequently used method is to smoothen the observed power forward
curve, that is, to derive a continuous curve of forward prices fˆt (u) from the discretely
observed power forwards Fˆ t (T1 , T2 ). A way to construct such a curve is proposed in
Benth et al. [5]. From a given a priori seasonal function, a fourth order polynomial
spline is fitted using a maximum smoothness criterion so that the implied power forward
prices are within the bid–ask spread of the market prices. Another similar approach is
described in Fleten and Lemming [11]. For each day, one can construct a time series
of such curves fˆt (u), t = 0, 1, . . . , and these can be used to infer estimates on the
volatility term structure σt (u) of the process ft (u). Obviously, one also gets estimates
on the drift of ft (u) from these data, where this drift is known as the risk premium in
the market.
A different way to approach the inference problem is to use implied volatilities
from quoted option prices in the market. This way to estimate is problematic since we
need to derive theoretical option pricing formulas for call and put options, which is not
straightforward at all due to the delivery period of the power forwards. Thus, we end
up with first having to perform a Monte Carlo simulation of prices in combination with
a numerical integration, a procedure which is slow when the goal is to derive implied
estimates on the volatility term structure σt (u). To speed up this process, one may
use some approximations of the dynamics of Ft (T1 , T2 ) where analytical (Black-76)
option pricing formulas become available. The validity of such approximations is the
target of the study in this paper.
One may leave completely the specification of ft (u), and directly specify the
dynamics of the power forwards Ft (T1 , T2 ), only for those being actually traded in
the market. This kind of LIBOR model for the power forward market is analyzed in
Benth and Koekebakker [4] and Kiesel et al. [17]. In the latter paper, they use it to find
implied estimates for the volatility term structure of power forwards in the German
EEX market.
5.3. POWER FORWARDS AND APPROXIMATION

BY GEOMETRIC BROWNIAN MOTION
In this Section, we analyze the time dynamics of power forwards resulting from the
dynamics of ft (u). Our standing assumption is the geometric Brownian motion struc-
ture of ft (u) defined in (5.6). We further analyze approximations of the power forward
price dynamics in terms of geometric Brownian motion, in particular the approxima-

tion suggested by Bjerksund et al. [8].
Following the calculation on page 170 in Benth et al. [6], we have
T2 T2 t
Ft (T1 , T2 ) = w(u, T1 , T2 )f0 (u)du + w(u, T1 , T2 ) σs (u)fs (u)dWs du
T1 T1 0
t T2
= F0 (T1 , T2 ) + w(u, T1 , T2 )σs (u)fs (u)dudWs ,
0 T1
where we have used the stochastic Fubini Theorem (see pages 159, 160 in Protter [20]).
Next, applying a straightforward integration by parts yields
T2
w(u, T1 , T2 )σs (u)fs (u)du
T1
T2 u
∂σs (u)
= σs (T2 )Fs (T1 , T2 ) − w(v, T1 , T2 )fs (v)dvdu.
T1 ∂u T1
Dividing and multiplying with w(v, T1 , u) in the dv-integral on the right-hand side,
and observing that w(v, T1 , T2 )/w(v, T1 , u) is independent of v, gives us the following
expression:
T2
w(u, T1 , T2 )σs (u)fs (u)du
T1
T2
∂σs (u) w(v, T1 , T2 )
= σs (T2 )Fs (T1 , T2 ) − Fs (T1 , u)du.
T1 ∂u w(v, T1 , u)
Collecting terms together, we have proven:
Proposition 5.1. Given the dynamics (5.6) for ft (u), the dynamics of the power for-
ward Ft (T1 , T2 ) is
T2
dFt (T1 , T2 ) ∂σt (u) w(v, T1 , T2 ) Ft (T1 , u)
= σt (T2 ) − du dWt , (5.9)
Ft (T1 , T2 ) T1 ∂u w(v, T1 , u) Ft (T1 , T2 )
where w(v, T1 , T2 )/w(v, T1 , u) is independent of v.
Although ft (u) has a simple geometric Brownian motion dynamics with maturity-
dependent volatility, the power forward has a complex dynamics which involves not
only the power forward Ft (T1 , T2 ) itself, but the states of all power forwards Ft (T1 , u)
for u ∈ (T1 , T2 ]. The geometric Brownian motion structure is thus not inherited from
ft (u). We also note that a volatility σt (u), which is not depending on u will have
∂σt (u)/∂u = 0, and we obtain a geometric Brownian motion dynamics as we already
saw above in the derivation of (5.8). In the general case, this is a rather complex model,
especially from the point of view of simulation and pricing of options since in principle
it involves an infinite number of power forwards.
100 Benth
We may also view the dynamics of Ft (T1 , T2 ) as a geometric Brownian motion

with stochastic volatility modeled through a factor process given by ft (u). Appealing
to the dynamics of ft (u), and dividing by Ft (T1 , T2 ), we obtain
T2
T w(u, T1 , T2 )σt (u)ft (u)du
dFt (T1 , T2 ) = 1 T2 Ft (T1 , T2 )dWt . (5.10)
T1 w(u, T 1 , T 2 )f t (u)du
We see that the dynamics of Ft (T1 , T2 ) has a stochastic volatility described as a ratio
of two weighted averages of ft (u). The stochasticity comes in through fluctuations
of ft (u) in time t. If σt (u) is rather flat as a function of maturity u, we expect the
stochastic volatility to be close to σt . This happens, say, when we have a volatility
function for which limu→∞ σt (u) = σ̂t . Then, for delivery periods in the long end of
the curve, that is, T1 − t large, we will approximately have
T2 T2
w(u, T1 , T2 )σt (u)ft (u)du ≈ σ̂t w(u, T1 , T2 )ft (u)du,
T1 T1
and hence,
dFt (T1 , T2 ) ≈ σ̂t Ft (T1 , T2 )dWt .
I.e., in the long end of the power forward curve, the prices move approximately accord-
ing to a geometric Brownian motion with maturity-independent volatility given as the
limit of σt (u) with respect to u. In the discussion leading to this result, we have implic-
itly assumed that ft (u) is well-behaved as a function of u ∈ [T1 , T2 ], for instance, that
it is continuous. As an example, consider σt (u) given as in (5.7). Then
lim σt (u) = σ0
u→∞
for all t ≥ 0. Thus, in this case, the power forward will for large values of T1 − t
behave approximately as a geometric Brownian motion with volatility given by the
long-term level σ0 . We note that closer to maturity the power forward will naturally
have increasing volatility due to the Samuelson effect of ft (u), and thus its dynamics
will depart from the constant volatility geometric Brownian motion.
However, one may ask the question whether there exist reasonable geometric
Brownian motion models, which approximate the power forward dynamics. Looking
at the mean-value theorem in calculus, we have that
T2
∗
ft (u (t)) = w(u, T1 , T2 )ft (u)du,
T1
∗
for some u (t) ∈ (T1 , T2 ). Hence,
Ft (T1 , T2 ) = ft (u∗ (t)),

which gives an explicit relation between a power forward price dynamics and a forward
price ft (u) being a geometric Brownian motion. However, the latter has a parameter
u, which in this case will depend on time t. The connection motivates to look for
approximative models, which indeed are lognormal processes.
Following the argument in Benth and Henriksen [3], we use a Taylor expansion
of the logarithmic function to find
1
2 ln(ft (u) + ft (v)) = ln ft (u) + ln ft (v) + (cosh(ln(ft (u)/ft (v))) − 1)
2
+ 2 ln(2) + O((ln(ft (u)/ft (v)))4 ).
Now, for two nearby delivery times u and v, ft (u) ≈ ft (v) as long as σ(t, u) is
sufficiently regular in u. Hence, we see that the logarithm of ft (u) + ft (v) is close to
the sum of logarithms of ft (u) and ft (v) and the constant 2 ln(2), which is following
a drifted Brownian motion. The crucial observation here is that there is the same
Brownian motion Wt driving both ft (u) and ft (v) making them perfectly correlated,
and it is only the regularity of σt (u) as a function of maturity that decides how good
the approximation is. Indeed, in Henriksen [14], it is demonstrated empirically that
a sum of positively correlated lognormal variables are very well approximated by a
lognormal variable. Of course, in our case, we have an integral of lognormal variables,
but still this discussion points toward the reasonability of geometric Brownian motion
approximations for power forwards.
We remark that a geometric Brownian motion dynamics for Ft (T1 , T2 ) in general
will violate the no-arbitrage condition (5.5) (see Lemma 6.1, page 168 in Benth et al.
[6]), and thus cannot be a valid dynamics for the whole power forward curve. However,
as dynamics for a contract with a specified delivery period [T1 , T2 ], it is arbitrage-free.
Since analytical pricing formulas for plain vanilla options are available for geometric
Bronwian motion dynamics, such approximations are particularly interesting.
5.3.1. A Geometric Brownian Motion Dynamics

by Volatility Averaging
In (5.10), divide and multiply with the weighted average of σ(t, u) in the numerator to
obtain
T2
dFt (T1 , T2 ) = w(u, T1 , T2 )σt (u)du
T1
T2
T wσ (t, u, T1 , T2 )ft (u)du
× 1 T2 Ft (T1 , T2 )dWt , (5.11)
T1 w(u, T1 , T2 )ft (u)du
102 Benth
where
w(u, T1 , T2 )σt (u)
wσ (t, u, T1 , T2 ) = T2 .
T1 w(v, T1 , T2 )σt (v)dv
T
Since wσ (t, u, T1 , T2 ) is non-negative and T12 wσ (t, u, T1 , T2 )du = 1, it is a weight-
ing function. Hence, the fraction on the right-hand side of the dynamics (5.11) is
the ratio between two weighted averages of ft (u) over u ∈ [T1 , T2 ]. As long as
wσ (t, u, T1 , T2 ) ≈ w(u, T1 , T2 ), this is close to one. This is equivalent to σt (u) being
approximately equal to its weighted average, i.e., being close to flat over the delivery
period. We consider an example, where this is true.
Consider σt (u) = σ exp(−α(u − t)) and w(u, T1 , T2 ) = 1/(T2 − T1 ). We find
αe−αu
wσ (t, u, T1 , T2 ) = .
e−αT1
− e−αT2
Note that ∂wσ (t, u, T1 , T2 )/∂u = −αwσ (t, u, T1 , T2 ) < 0, and the weighting function
is decreasing as a function of u. Its maximal value becomes
wσ (t, T1 , T1 , T2 ) = α(1 − e−α(T2 −T1 ) )−1 ,
and minimal value
wσ (t, T2 , T1 , T2 ) = α(eα(T2 −T1 ) − 1)−1 .
Moreover,
wσ (t, T1 , T1 , T2 ) − wσ (t, T2 , T1 , T2 ) = α.
If α is small, then the variation in wσ is correspondingly small. Furthermore, as long
as α(T2 − T1 ) is small, we have
eα(T2 −T1 ) ≈ 1 + α(T2 − T1 ).
Hence,
1
wσ (t, u, T1 , T2 ) ≈ = w(u, T1 , T2 ).
T2 − T 1
Thus, we have in this case that
T2
dFt (T1 , T2 ) ≈ w(u, T1 , T2 )σt (u)duFt (T1 , T2 )dWt .
T1
This is the approximation of the power forward price dynamics suggested by Bjerksund
et al. [8], and we introduce the BRS-approximation as
dFtBRS (T1 , T2 ) = BRS
t (T1 , T2 )FtBRS (T1 , T2 )dWt (5.12)
with the BRS-volatility function given by
T2
BRS
t (T1 , T2 ) = w(u, T1 , T2 )σt (u)du. (5.13)
T1
The BRS-approximation will play a central role in the analysis to follow, since this
is the benchmark model for many applications and seems to be frequently used in
practice.
The approximation in (5.12) can also be argued for by looking at the returns of
ft (u). Thinking of Ft (T1 , T2 ) as a portfolio of ft (u)’s, it may seem natural that the
return from Ft (T1 , T2 ) is the sum of returns from the “assets” in the portfolio, namely
ft (u) for u ∈ [T1 , T2 ]. Hence,
T2 T2
dFt (T1 , T2 ) dft (u)
≈ w(u, T1 , T2 ) du = w(u, T1 , T2 )σt (u)du dWt .
Ft (T1 , T2 ) T1 ft (u) T1
In the last equality, we have used that

T2 T2
dft (u)
w(u, T1 , T2 ) du = w(u, T1 , T2 )σt (u)du dWt .
T1 ft (u) T1
In effect, in the above approximation, we are boldly assuming that the self-financing
property holds. Thus, we have again reached the approximative model in (5.12). It is
of course a question whether the return of a power forward approximately is equal to
the weighted average of the return of ft (u) in general.
5.3.2. A Geometric Brownian Motion Dynamics

by Moment Matching
In this Subsection, we propose and analyze an alternative approximation procedure to
the one discussed above.
Since the power forward dynamics is the weighted integral over maturity u of
ft (u), it is the weighted average of lognormal random variables. In general, such an
integral will not be lognormal. However, we may still ask for a geometric Brownian
motion dynamics that approximates Ft (T1 , T2 ), and in order to be reasonably close to
the distribution of F we construct in this Subsection a model that matches the first two
moments.
Moment matching is a much-used technique when pricing basket options, since
it allows for explicit pricing formulas. Extensive studies of its performance, both
theoretical and empirical, are provided in Zacks and Sokos [21], Asmussen and Rojas-
Nandayapa [1], Levy [18], Henriksen [14] and Hoedemakers [15].
Define the process Ftm (T1 , T2 ) by
dFtm (T1 , T2 ) = m m
t (T1 , T2 ) Ft (T1 , T2 )dWt , (5.14)
where the subscript “m” indicates that we are looking for a dynamic matching the first
two moments of F . The deterministic volatility function t → m t (T1 , T2 ) is assumed
to be square integrable for t ∈ [0, T1 ] to ensure that Ftm (T1 , T2 ) is a martingale for
104 Benth
any fixed T1 , T2 . Our aim is to find F0m (T1 , T2 ) and m

t (T1 , T2 ) such that the first two
moments of Ft (T1 , T2 ) match those of Ft (T1 , T2 ) for all 0 ≤ t ≤ T1 < T2 .
m
First, by the martingale properties of Ftm (T1 , T2 ) and ft (u) we find that
T2
E[Ftm (T1 , T2 )] = F0m (T1 , T2 ) = w(u, T1 , T2 )f0 (u)du = F0 (T1 , T2 ).
T1
Thus, the first moment condition gives
F0m (T1 , T2 ) = F0 (T1 , T2 ).
We next calculate the second moment of Ft (T1 , T2 ). From integration-by-parts, we

have
T2 2 T2 v
w(u, T1 , T2 )ft (u)du = 2 w(v, T1 , T2 )w(u, T1 , T2 )ft (v)ft (u)dudv.
T1 T1 T1
Taking the expectation yields

T2 v
E[Ft2 (T1 , T2 )] =2 w(v, T1 , T2 )w(u; T1 , T2 )E[ft (u)ft (v)]dudv.
T1 T1
The expectation inside the double integral on the right-hand side can be calculated by
appealing to well-known properties of geometric Brownian motion (note that we have
u ≤ v here),

1 t 2
E[ft (u)ft (v)] = f0 (u)f0 (v) exp − σs (u) + σs2 (v)ds
2 0
t
× E exp σs (u) + σs (v)dWs
0

1 t 2
= f0 (u)f0 (v) exp − σ (u) + σs (v)ds
2
2 0 s
t
1
exp (σs (u) + σs (v))2 ds
2 0
t
= f0 (u)f0 (v) exp σs (u)σs (v)ds .
0
On the other hand, we find

t
E[(Ftm )2 (T1 , T2 )] = F02 (T1 , T2 ) exp (m 2
s ) (T1 , T2 )ds .
0
Hence, matching the second moment gives the equation
t
F02 (T1 , T2 ) exp (m 2
s ) (T1 , T2 )ds
0
T2 v
=2 w(u, T1 , T2 )w(v, T1 , T2 )f0 (u)f0 (v)
T1 T1
t
× exp σs (u)σs (v)ds dudv.
0
To this end, introduce the mapping η → ξ(t, T1 , T2 ; η) of functions η: [T1 , T2 ] → R,
T2 v
ξ(t, T1 , T2 ; η) = w(u, T1 , T2 )w(v, T1 , T2 )f0 (u)f0 (v)
T1 T1
t
×e 0 σs (u)σs (v)ds
η(u)η(v)dudv. (5.15)
We implicitly suppose that η is sufficiently regular (continuous on [T1 , T2 ], say) in

order to make ξ well-defined. Taking logarithms and differentiating both sides with
respect to t, gives the formula for m :
ξ(t, T1 , T2 ; σt (·))
t ) (T1 , T2 ) =
2
(m . (5.16)
ξ(t, T1 , T2 ; 1)
For a given volatility function σt (u), we can calculate m t (T1 , T2 ) from (5.16).
From the definition of (5.15), we see that m
t (T 1 , T 2 ) depends on the initial forward
curve f0 (u) as well as the volatility σt (u) and the weighting function w(u, T1 , T2 ).
The integrand in the double integral forming ξ(t, T1 , T2 ; η) is rather complex due
t
to the exponentiating of 0 σs (u)σs (v)ds, and will not in general admit any simple
closed-form expression as is mostly the case for the BRS-volatility BRS t (T1 , T2 ). For
example, choosing the standard volatility σt (u) as in (5.7) leads to a double integral
of the exponential of an exponential. Hence, in order to calculate m t (T1 , T2 ), we
must perform a numerical integration. Even worse, we need to do such a numerical
integration at each time t we want to have the value of Ftm (T1 , T2 ) since the expression
inside the integrals is t-dependent. This may become very time consuming in practice.
However, when pricing a plain vanilla call option, we get away with one such numerical
integration, as we see from the Black-76 Formula (see Sec. 5.4). In any case, the
expression for the volatility resulting from moment matching does not seem to be as
operable in practice as for instance the BRS-volatility.
106 Benth
Let us compare m t (T1 , T2 ) with the BRS-volatility in (5.13). Note that we may
write
T2 2
ξ(t, T1 , T2 ; σt (·)) = w(u, T1 , T2 )σt (u)du ξ(t, T1 , T2 ; σ t (·, T1 , T2 )),
T1
with
σt (u)
σ̄t (u, T1 , T2 ) = T2 .
If
w(u, T1 , T2 )σt (u)
wσ (t, T1 , T2 ) = T2 ≈ w(u, T1 , T2 ),
we find
T2 2
ξ(t, T1 , T2 ; σt (·)) ≈ w(u, T1 , T2 )σt (u)du ξ(t, T1 , T2 ; 1).
T1
Recall that if σt (u) is given by (5.7) and w(u, T1 , T2 ) = 1/(T2 − T1 ), this property
holds as long as α, the speed of mean–reversion, is small. Hence,
t (T1 , T2 ) ≈ t
BRS
m (T1 , T2 ).
The two ways of finding a “reasonable” geometric Brownian motion specification will
therefore in some relevant cases be approximately equal. However, the expression for
BRS
t (T1 , T2 ) is considerably simpler to find, since it allows for analytical expressions
in most interesting cases, which is not the case for m t (T1 , T2 ). We shall therefore
concentrate our analysis on the BRS-approximation.
5.3.3. The Covariance Structure Between Power Forwards

We include a discussion of the covariance between two power forwards. We
compare with the covariance structure implied by a geometric Brownian motion
approximation
d F̃ t (T1 , T2 ) = t (T1 , T2 )F̃ t (T1 , T2 )dWt ,

BRS
where t (T1 , T2 ) may be one of the two choices m t (T1 , T2 ) or t (T1 , T2 ) intro-
duced. Naturally, we have F̃ 0 (T1 , T2 ) = F0 (T1 , T2 ).
Let now s ≤ t, and consider two delivery periods [T1 , T2 ] and [T3 , T4 ] which may
be overlapping, but where we suppose T1 ≤ T3 or T2 ≤ T4 . From similar calculations
as in the previous Subsection we derive the following Proposition.
Proposition 5.2. It holds that

T2 T4
Cov(Fs (T1 , T2 ), Ft (T3 , T4 )) = w(u, T1 , T2 )w(v, T3 , T4 )f0 (u)f0 (v)
T1 T3
s
× (e 0 σr (u)σr (v)dr
− 1)dudv, (5.17)
and
Cov(F̃ s (T1 , T2 ), F̃ t (T3 , T4 ))

s
= F0 (T1 , T2 )F0 (T3 , T4 )(e 0 r (T1 ,T2 )r (T3 ,T4 )dr
− 1). (5.18)
Let us compare the two expressions for the covariance. Introduce the weight
function
w(u, T1 , T2 )f0 (u) w(u, T1 , T2 )f0 (u)
wf (u, T1 , T2 ) = T2 = ,
F0 (T1 , T2 )
T1 w(v, T1 , T2 )f0 (v)dv
to find
Cov(Fs (T1 , T2 ), Ft (T3 , T4 ))
T2 T4
= F0 (T1 , T2 )F0 (T3 , T4 ) wf (u, T1 , T2 )wf (v, T3 , T4 )
T1 T3
s
× (e 0 σr (u)σr (v)dr
− 1)dudv,
Jensen’s Inequality for the convex function exp(x) now gives
Cov(Fs (T1 , T2 ), Ft (T3 , T4 )) ≥ F0 (T1 , T2 )F0 (T3 , T4 )

s T2 T4
0 ( T wf (u,T1 ,T2 )σr (u)du T wf (u,T3 ,T4 )σr (u)du)dr
× (e 1 3 − 1).
Moreover, as long as wf (u, T1 , T2 ) ≈ w(u, T1 , T2 ), we obtain
Cov(Fs (T1 , T2 ), Ft (T3 , T4 )) ≥ Cov(FsBRS (T1 , T2 ), FtBRS (T3 , T4 )).
Hence, the BRS-approximation underestimates the true covariance between power

forwards with different delivery periods and time points. This may have consequences
when pricing path-dependent or spread options on power forwards. Note that from
the above considerations the moment approximation F m has the same variance as F ,
however, not necessarily the same covariance structure.
108 Benth
5.3.4. The Distribution of a Power Forward

We end this section by investigating the distribution of a power forward. More specif-
ically, we show that the power forward is bounded from below and above by two
lognormal stochastic processes.
Proposition 5.3. For all 0 ≤ t ≤ T1 < T2 , it holds that

f
c(t, T1 , T2 )FtBRS (T1 , T2 ) ≤ Ft (T1 , T2 ) ≤ Ft (T1 , T2 )
f
where Ft (T1 , T2 ) is the geometric Brownian motion
T2
f f
dFt (T1 , T2 ) = wf (u, T1 , T2 )σt (u)duFt (T1 , T2 )dWt .
T1
T2
Here, wf (u, T1 , T2 ) = w(u, T1 , T2 )f0 (u)/ T1 w(v, T1 , T2 )f0 (v)dv and
t T2
1
c(t, T1 , T2 ) = exp (s ) (T1 , T2 ) −
BRS 2 2
w(u, T1 , T2 )σs (u)du ds
2 0 T1
T
exp( T12 w(u, T1 , T2 ) ln f0 (u)du)
× .
F0 (T1 , T2 )
Proof. To prove the lower bound, use Jensen’s Inequality for the concave function
ln x to find
T2 T2
ln w(u, T1 , T2 )ft (u)du ≥ w(u, T1 , T2 ) ln ft (u)du.
T1 T1
Now, from the geometric Brownian motion dynamics of ft (u), we have

T2 T2
ln w(u, T1 , T2 )ft (u)du ≥ w(u, T1 , T2 ) ln f0 (u)du
T1 T1

1 t T2
− w(u, T1 , T2 )σs2 (u)duds
2 0 T1
t T2
+ w(u, T1 , T2 )σs (u)dudWs .
0 T1
Thus, the power forward is dominating a lognormally distributed stochastic process

Xt (T1 , T2 ), where ln Xt (T1 , T2 ) has mean
T2
1 t T2
w(u, T1 , T2 ) ln f0 (u)du − w(u, T1 , T2 )σs2 (u)duds
T1 2 0 T1
and variance
t T2 2
w(u, T1 , T2 )σs (u)du ds.
0 T1
The latter is the variance of the logreturn from the BRS-approximation (5.12), where
we recall from (5.13) that
T2
BRS
t (T1 , T2 ) = w(u, T1 , T2 )σt (u)du.
T1
By the definition of FtBRS (T1 , T2 ) and the deterministic function c(t, T1 , T2 ) in the
Proposition, we find after taking exponentials
Ft (T1 , T2 ) ≥ c(t, T1 , T2 )FtBRS (T1 , T2 ).
This proves the lower bound.

From the definition of wf (u, T1 , T2 ), a straightforward calculation gives
T2
w(u, T1 , T2 )ft (u)du
T1
T2 t
1 t 2
= w(u, T1 , T2 )f0 (u) exp − σ (u)ds + σs (u)dWs du
T1 2 0 s 0
T2 t
1 t 2
= F0 (T1 , T2 ) wf (u, T1 , T2 ) · exp − σs (u)ds + σs (u)dWs du.
T1 2 0 0
Again appealing to Jensen’s Inequality, but now using the convex function exp(x), we
find
T2 t
1 t 2
wf (u, T1 , T2 ) exp − σs (u)ds + σs (u)dWs du
T1 2 0 0

1 t T2
≤ exp − wf (u, T1 , T2 )σs2 (u)duds
2 0 T1
t T2
+ wf (u, T1 , T2 )σs (u)dudWs .
0 T1
110 Benth
f
Thus, by the definition of Ft (T1 , T2 ),
T2 2
f 1 t T2
w(u, T1 , T2 )ft (u)du ≤ Ft (T1 , T2 ) exp wf (u, T1 , T2 )σs (u)du
T1 2 0 T1
T2
− 2
wf (u, T1 , T2 )σs (u)du ds
T1
f
≤ Ft (T1 , T2 ).
In the last inequality, we applied Jensen’s Inequality to the convex function x2 . This
shows the upper bound, and the Proposition is proved.
In the lower bound for Ft (T1 , T2 ), the deterministic function c(t, T1 , T2 ) is less that
one. This we see by using Jensen’s Inequality on the two convex functions exp(x)
and x2 . This means that the lower bound of Ft (T1 , T2 ) is less than FtBRS (T1 , T2 ), and
in theory the power forward price can be below the BRS-approximation. However,
there is a geometric Brownian motion bounding the power forward from above. This
geometric Brownian motion may even bound the BRS-approximation.
5.3.5. Numerical Analysis of the Power Forward Distribution

We investigate the distribution of power forwards from a numerical point of view,
and choose for this purpose a volatility function σt (u) given by (5.7). We treat two
different scenarios. First, we have a “moderate” market with σ0 = 20%, σ1 = 50%,
and α = 0.05, corresponding to approximately a half-life of 14 days. The market
is “moderate” because we have a very slow mean–reversion along with a volatility,
which is relatively low for markets like electricity. The “spiky” market has σ0 = 20%,
σ1 = 300%, and α = 0.2, meaning a half-life of 3.5 days. Hence, we have very fast
mean–reversion along with an extreme volatility (although the stationary volatility
is the same), on a level not far from what one may observe in electricity markets.
Further, it is assumed that f0 (u) = 10 for all delivery times u, and the weight function
is w(u, T1 , T2 ) = 1/(T2 − T1 ). This implies that F0 (T1 , T2 ) = 10.
We look at two power forward contracts, both starting delivery in 50 days, T1 = 50.
The first contract delivers over a week, T2 = 55, and the latter over a quarter, T2 = 110,
where we count five trading days in a week. The power forward prices are simulated
using 5000 Monte Carlo outcomes, and a Riemann approximation of the integration
over the delivery period. In Figs. 5.1–5.3, we have plotted the resulting empirical
distributions of the weekly and quarterly power forwards at times t = 1, t = 25,
and t = 50. The empirical densities have been fitted using a kernel density estimator.
The left column in each figure shows the weekly contracts, while the quarterly are
Figure 5.1 The distributions from simulations of a weekly (left column) and quarterly (right
column) power forward contract at time t = 1 with row 1 showing the “moderate” market
scenario, whereas rows 2 shows the “spiky” market scenarios. The BRS approximation is shown
in dashed lines, all distributions are plotted with a logarithmic frequency axis.
depicted in the right column. The BRS approximation is included with a dashed line,
using a logarithmic scale on the frequency axis. The first row in each figure shows the
“moderate” scenario, while the second row depicts the “spiky” case.
We observe that the distributions become wider when approaching T1 , in line
with the fact that σt (u) is increasing when approaching time to maturity. We notice
that the BRS approximation has close to an excellent fit for all sampling times t, the
two contract types, and the different market scenarios. This indicates that the BRS
approximation works excellently for short- and long-delivery periods, no matter how
far or close to start of delivery of the contract we are. However, one may spot a
slight underestimation of the true distribution for the weekly contract in the “spiky”
market scenario with t = 50. It seems that the BRS approximation for this situation is
underestimating in both tails.
To investigate this closer, we looked at the distribution of a weekly and monthly
power forward, both starting at T1 = 50, and maturing at T2 = 55 and T2 = 70
respectively. Further, since the effect seems to come from the exponential increase
112 Benth
column) power forward contract at time t = 25 with row 1 showing the “moderate” market
scenario, whereas row 2 shows the “spiky” market scenarios. The BRS approximation is shown
in volatlity, we let σ0 = 0 in the “spiky” market scenario. In Fig. 5.4, we plot the
distributions for the two contracts in the two market scenarios at time t = 50. We
clearly see that the “spiky” market scenario produces a distribution for the power
forward, which has heavier tails than the BRS approximation. The weekly contract is
most extreme, whereas the monthly only has a heavier right tail. The effect is very small
in the “moderate” market scenario, perhaps most pronounced for the weekly contract.
It thus seems like that the BRS approximation becomes better when the delivery period
increases, and the farther away we are from T1 , the start of delivery.
To further analyze the distributional differences between the BRS approximation
and the power forward, we include in Fig. 5.5 plots of the 1%, 5%, 95%, and 99%
quantiles of the two for all times t = 40 up to t = 50, the start of delivery. We present
the weekly and monthly contracts, separating the moderate and spiky market scenar-
ios. The “moderate” market does not show any difference between the quantiles of
the power forward and its BRS approximation. Here, the tails are captured excellently
by the BRS approximation. The BRS approximation fails seriously, however, on the
95% and 99% quantiles of both, weekly and monthly forward contracts in the “spiky”
column) power forward contract at times t = 50 with row 1 showing the “moderate” market
scenario, whereas row 2 shows the “spiky” market scenarios. The BRS approximation is shown
scenario. In fact, the quantiles are close to 5% underestimated by the BRS aproxi-
mation. There is also an underestimation of the lower quantiles, in particular for the
weekly contract. From the figure, we also see how the interplay between volatility
and mean–reversion makes the “moderate” market scenario being more risky far from
delivery, while the “spiky” regime becomes gradually more riskier toward the start of
delivery, and eventually, for times t close to 50, being significantly more volatile than
the “moderate” scenario. If we would include a contribution from σ0 in the “spiky”
scenario, the effects would be reduced. Furthermore, we clearly see that the longer the
delivery period, the less volatile are the prices. There is a significant smoothing effect
in the length of delivery period.
From these examples, we conclude that the BRS approximation works excellently
for cases, where the market is not mean–reverting strongly and where the volatility
is not high (in relative terms). When we use the approximation for markets with very
fast mean–reversion and high volatility, the tails are not well explained by the BRS
approximation. It seems to underestimate significantly the extreme quantiles, an effect
which will lead to an underestimation of option prices if considering for instance far
out-of-the-money calls.
114 Benth
Figure 5.4 The distributions of a weekly (left column) and monthly (right column) power
forward contracts at time t = 50 with row 1 showing the “moderate” market scenario, whereas
row 2 shows the “spiky” market scenarios. The BRS approximation is shown in dashed lines,
all distributions are plotted with a logarithmic frequency axis.
5.4. PRICING OF OPTIONS ON POWER FORWARDS
In this section, we study options on power forwards. We analyze in particular the

option prices resulting from the BRS approximation to power forwards. Since this is
a geometric Brownian motion model, the Black-76 formula is available for pricing of
plain vanilla call and put options. We begin by recalling this formula.
In the famous paper by Black [7], the Black-76 Formula was derived for a call
option on a forward contract with price dynamics given by a geometric Brownian
motion having constant volatility. It is simple to extend for a time-dependent volatility,
as is the case for the BRS approximation. Considering the dynamics of FtBRS (T1 , T2 )
in (5.12), we have the following result:
Proposition 5.4. Let r be the risk-free interest rate, K the strike, and 0 ≤ T ≤ T1
the exercise time for a call option written on a forward contract with price process
FtBRS (T1 , T2 ) defined as in (5.12). Then, the arbitrage-free option price at time t ≤ T is
Pt (T, K, r) = e−r(T −t) {FtBRS (T1 , T2 )(d1 ) − K(d2 )}

18 18
16 16
14 14
12 12
10 10
8 8
6 6
4 4
40 45 50 40 45 50
13 13
12.5 12.5
12 12
11.5 11.5
11 11
10.5 10.5
10 10
9.5 9.5
9 9
8.5 8.5
8 8
40 45 50 40 45 50
Figure 5.5 The 1%, 5%, 95%, and 99% quantiles of a weekly (top row) and monthly (bottom
row) power forward contracts at all times t up to ten days prior to start of delivery. Left column
shows the case of “moderate” market, while the right row depicts the results for the “spiky”
market. The BRS approximation is shown with slashed lines.
where

T
d1 = d2 + (BRS
s )2 (T1 , T2 )ds
t
T
ln(FtBRS (T1 , T2 )/K) − 0.5 t (BRS s )2 (T1 , T2 )ds
d2 =
T BRS )2 (T , T )ds
t (s 1 2
and is the cumulative standard normal distribution function.

116 Benth
Proof. See page 239 in Benth et al. [6] for a proof.
For many relevant cases like the various choices of σt (u) considered in this paper,
the integral of (BRS
s )2 (T1 , T2 ) in the expression for the Black-76 price can be ana-
lytically calculated, and hence the formula provides a very rapid way to price call
options. Note that the moment matching volatility m t (T1 , T2 ) defined in (5.16) can
be substituted with the BRS volatility in the option pricing formula. However, the
definition of mt (T1 , T2 ) is complicated, and for the interesting situations it does not
have any analytical expression, and numerical integration must be used to price options.
In fact, one must already use a numerical approach to integrate σt (u) and the initial
forward curve f0 (u) to obtain the moment-matching volatility m t (T1 , T2 ). This may
be time consuming and not practical, in particular if we want to price dynamically or
to derive a hedge. In such a situation, we must update the volatility m at each time
step, which would be significantly more efficient to do with the BRS approximation.
As a numerical example, consider a call option on a power forward with weekly
delivery. The fixed-maturity volatility σt (u) is again given by (5.7), and as usual we
separate between a “moderate” and a “spiky” market scenario. The latter has parameters
specified as σ0 = 0, σ1 = 300%, and α = 0.2, whereas the “moderate” market scenario
has σ0 = 20%, σ1 = 50%, and α = 0.05. We know from the previous section that in
the “spiky” scenario the BRS approximation failed to capture the tails of the power
forward distribution. In this example, we investigate the consequences on call option
pricing, and in particular we focus on options which are far-out-of the money. The
initial forward curve is f0 (u) = F0 (T1 , T2 ) = 10, where we have used the weight
function w(u, T1 , T2 ) = 1/(T2 −T1 ). The options are based on a weekly power forward
contract, starting delivery at time T1 = 50. Further, since the deviation of the BRS
approximation from the power forward is greatest at start of delivery, we consider
options with exercise time T = 50. The risk-free interest rate is set equal to r = 5%.
In Table 5.1, we report the results from the numerical example. The power for-
ward option prices are based on 10,000 Monte Carlo simulations, while the BRS
Table 5.1 Call Option Prices on Power Forward and Its BRS Approxi-
mation. The Power Forward Has a Weekly Delivery from Time T1 = 50,
and Exercise Time Is T = 50.
Strike “Moderate” power BRS “Spiky” power BRS
9 1.25 1.25 1.43 1.31

10 0.68 0.67 0.90 0.75
11 0.33 0.32 0.53 0.39
12 0.15 0.13 0.30 0.18
13 0.06 0.05 0.17 0.08
approximation is resulting from the Black-76 formula. We observe that there is hardly
any difference in the “moderate” scenario, in line with the fact that the BRS approxima-
tion is fitting the power forward distribution extremely well in this situation. However,
when we let the mean–reversion increase and the spot volatility σ1 be very high,
there is a significant effect on option prices. We know that the BRS approximation
underestimates the tails of the power forward distribution. This results in an under-
estimation of the option prices when using the BRS approximation and the Black-76
formula. From Table 5.1, we observe that options prices are indeed lower for the BRS
approximation. Already for an in-the-money option with strike K = 9, the price is
about 9% understimated by the BRS approximation. Looking at the extreme K = 13,
we have close to 50% underestimation of the true price. Hence, the BRS approximation
may be seriously flawed in situations with a very steep volatility curve.
We also know from the analysis of the power forward and its BRS approximation
that the covariance structure between different contracts are not matching. In fact,
the BRS approximation is also underestimating this. We consider an example of a
calendar spread option, where we price options based on the difference between two
power forwards with different delivery periods. For the BRS approximation, we have
a Margrabe Formula for the price (see Margrabe [19]):
Proposition 5.5. The price at time t of a call option on the difference FtBRS (T1 , T2 ) −
FtBRS (T3 , T4 ) with exercise time T, where min(T1 , T2 ) ≥ T ≥ t, strike 0, and interest
rate r is given by
Pt (T, r) = e−r(T −t) {FtBRS (T1 , T2 )(d + t (T )) − FtBRS (T3 , T4 )(d)}
where
ln(FtBRS (T1 , T2 )/FtBRS (T3 , T4 )) − 0.52t (T )
d= ,
t (T )
T
BRS 2
t (T ) =
2
s (T1 , T2 ) − BRS s (T3 , T4 ) ds,
t
and is the standard normal cumulative probability distribution function.
Proof. We include the proof for convenience. Let for simplicity t = 0, and factorize
out by FTBRS (T3 , T4 ) from the price to get
E[max(FTBRS (T1 , T2 ) − FTBRS (T3 , T4 ), 0)]

BRS
FT (T1 , T2 ) d Q̃
= F0 (T3 , T4 )E max
BRS
− 1, 0
FTBRS (T3 , T4 ) dQ
118 Benth
with

d Q̃ T
1 T
= exp BRS
s (T3 , T4 )dWs − (BRS
s )2
(T3 , T4 )ds .
dQ 0 2 0
Appealing to the Girsanov Theorem, we have that

d W̃t = dWt − BRS
t (T3 , T4 )dt
is a Q̃-Brownian motion on [0, T ]. Now, since

FTBRS (T1 , T2 ) F0BRS (T1 , T2 ) 1 T BRS 2
BRS
= BRS
· exp − s (T1 , T2 ) − BRS
s (T3 , T4 ) ds
FT (T3 , T4 ) F0 (T3 , T4 ) 2 0
T
+ BRS
s (T 1 , T 2 ) − BRS
s (T3 , T4 )d W̃ s ,
0
the result follows by a straightforward calculation using well-known properties of the

normal distribution.
In our numerical example, we consider two call option contracts. The first is a call
on the spread of two weekly contracts, one delivering from T1 = 50 to T2 = 55, and
the other over the time interval T1 = 70 to T2 = 75. The second is a call on the spread
of a weekly contract and a monthly, where the weekly is as the first power forward
above, and the monthly start delivering at T3 = 50, and ends at T4 = 70. The two
options are supposed to mimic a spread on power forward delivering far apart, and a
spread of two overlapping power forwards.
We consider an exercise time T = 50, the beginning of delivery of the first weekly
contract. Option prices are calculated in both the “moderate” and “spiky” scenarios
described above. The BRS approximation yields analytical prices by the Margrabe
formula in Proposition 5.5, while the “true” prices based on power forwards must be
simulated by Monte Carlo. We used 100,000 outcomes, a figure that gave sufficient
accuracy for our numerical example. The results are reported in Table 5.2. It is hard to
detect any significant difference between the real prices and the approximative ones
in any of the two markets scenarios. Checking various other exercise times T < 50
did not change the conclusions. Hence, although there is a difference in the covariance
structure between the BRS approximation and the power forward, this does not seem
to have any significant effect on calendar spreads. Due to the analyticity of the calendar
spread option price based on the BRS approximation, this is much more attractive to
use in practice since Monte Carlo is very slow.
There may be other specifications of the volatility structure that indeed gives
significant mispricing of calendar spread options when using the BRS approximation.
Inspecting the numbers in Table 5.2 closer, we observe that in all cases except the
“spiky” market scenario with two weekly contracts, the BRS approximation gives
Table 5.2 Calendar Spread Option Prices on Power Forward and

Its BRS Approximation. The Exercise Time is T = 50.
Week-week power BRS Week-month power BRS
“Moderate” 0.22 0.22 0.10 0.10

“Spiky” 0.72 0.73 0.46 0.46
an underestimation compared to the “true” price. This understimation is very small,

and one must be careful since the power forward spread prices are based on Monte
Carlo. However, this is a sign that there may exist specifications, where the BRS
approximation gives wrong prices.
5.5. CONCLUSION
In this paper, we have analyzed the distributional properties of power forward contracts.
Power forward contracts deliver electricity over a specified period, and can be viewed as
a portfolio of forwards with maturity at each time instant in the delivery period. We have
investigated the implied power forward dynamics from a geometric Brownian motion
specification of the forward price. The implied dynamics is not in general a geometric
Brownian motion, however, as it turns out, can be reasonably well approximated by
one. We show that there exist upper and lower bounds in terms of geometric Brownian
motions for the power forwards.
We have spent most of our efforts in this paper to consider the BRS approximation,
where the power forward dynamics is approximated by a geometric Brownian motion,
with a volatility specified as the average of the fixed-delivery forward volatility. Both,
analytically and emprically, the approximation works very well. However, if the market
has very strong mean–reversion and excessively high volatility (as is the case for
many electricity markets), the BRS approximation may underestimate significantly
the tails of the power forward distribution. We show that this may have consequences
in risk management and option pricing, where the BRS approximation will seriously
understimate the true risk and price. On the other hand, it works excellently in more
moderate situations.
There are also signs of mis-representation of the true covariance structure between
power forward contracts by the BRS approximation. By looking at various calendar
spread options, it seems that this is not very significant in practice. However, the BRS
approximation allows for an analytical Margrabe formula to price calendar spread
options, which is far superior in efficiency compared to the Monte Carlo method
which must be used to price spread options on power forwards.
120 Benth
For basket option pricing, one is frequently using moment matching techniques
to fit a lognormal variable to a sum of lognormals. This approach can also be used for
power forwards, and provides an explicit representation of the approximating volatility.
However, this moment-matched volatility is in general very complicated and requires
numerical integration to be evaluated, whereas the BRS volatility is analytically avail-
able. Also, in many situations, the BRS volatility is a reasonable approximation of the
moment-matched volatility. Hence, the BRS approximation is to be preferred among
the two.
In this paper, we have only treated the case of one driving Brownian motion for
the dynamics. In practice, the dependence structure among different power forwards
is far more complicated (see Benth et al. [6]), and more factors are called for. Many
of the calculations above can be easily extended to cover such models. However,
another feature that should be investigated is the non-normality of returns of power
forwards. Empirical analysis of power forward prices has shown that the log returns
are significantly heavy tailed (see Benth and Koekebakker [4]). Indeed, as shown in
Frestad et al. [12], the normal inverse Gaussian (NIG) distribution fits the log returns
on power forwards with delivery periods ranging from weekly to yearly extremely
well. The four-parameter NIG distribution was introduced in finance by Barndorff-
Nielsen [2], and has later proved to be a suitable distribution class to model the log
returns of financial data. It has the normal distribution as a limiting case, and Frestad
et al. [12] demonstrate statistically that the estimated NIG distributions of the power
forward contracts are far from normal. To model dynamics, matching these statistical
observations requires the use of Lévy processes.
To indicate how such an extension could be achieved under the HJM paradigm
in our context, one could state an exponential Lévy dynamics for the forward process
ft (u) as follows:
ft (u) = f0 (u) exp(γt (u)Lt ). (5.19)
Here, Lt is a Lévy process with NIG marginals, say. The maturity dependence of ft (u) is
modeled using the deterministic scaling function γt (u), which plays much the same role
as the volatility function σt (u). To have a risk–neutral dynamics, we must require that
E[exp(γt (u)Lt )] = 1,
for all t ≥ 0 and u ≥ t. The naive BRS approximation in this case would be to consider
FtBRS (T1 , T2 ) = F0BRS (T1 , T2 ) exp(

BRS
t (T1 , T2 )Lt ),
with
T2

BRS
t (T1 , T2 ) = w(u, T1 , T2 )γt (u)du.
T1
We immediately spot a first problem in having a martingale dynamics of FtBRS (T1 , T2 ).

This and other questions on the validity of such an approximation are left for future
studies.
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[1] Asmussen, S and L Rojas-Nandayapa (2006). Sums of dependent lognormal random

variables: Asymptotics and simulation. Research Report, Thiele Center, University of
Aarhus.
[2] Barndorff-Nielsen, OE (1998). Processes of normal inverse Gaussian type. Finance and
Stochastics, 2(1), 41–68.
[3] Benth, FE and PN Henriksen (2008). Pricing basket options using univariate normal inverse
Gaussian approximation. Statistical Research Report, No. 3, Department of Mathematics,
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tracts. Energy Economics, 30(3), 1116–1157.
[5] Benth, FE, S Koekebakker and F Ollmar (2007). Extracting and applying smooth for-
ward curves from average-based commodity contracts with seasonal variation. Journal of
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and Related Markets, World Scientific.
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[9] Clewlow, L and C Strickland (2000). Energy Derivatives: Pricing and Risk Management.
Lacima Publications.
[10] Eydeland, A and K Wolyniec (2003). Energy and Power Risk Management. John Wiley &
Sons.
[11] Fleten, SE and J Lemming (2003). Constructing forward price curves in electricity markets.
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[12] Frestad, D, FE Benth and S Koekebakker (2007). Modelling the term structure dynamics
in the Nordic electricity swap market. To appear in Journal of Energy.
[13] Geman, H (2005). Commodities and Commodity Derivatives. Wiley-Finance, John Wiley
and Sons.
[14] Henriksen, PN (2008). Lognormal moment matching and pricing of basket options.
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[15] Hoedemakers, T (2005). Modern Reserving Techniques for Insurance Business. PhD
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122 Benth
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PRICING CERTIFICATES UNDER

ISSUER RISK
6
BARBARA GÖTZ∗,‡ , RUDI ZAGST∗,§
and MARCOS ESCOBAR†,¶
∗
Technische Universität München,
Boltzmannstrasse 3, 85748 Garching, Germany
†
Department of Mathematics, Ryerson University,
350 Victoria St. Toronto, M5B 2K3, Ontario, Canada
‡
goetz@tum.de; barbara.goetz@tum.de
§
zagst@ma.tum.de; zagst@tum.de
¶
escobar@ryerson.ca
Certificates have become very popular in Germany, Austria, and Switzerland in the
last few years. From a technical and legal point of view they are bonds. Thus, their
value actually also depends on the rating and creditworthiness of the issuing company.
This aspect is in general neglected in the pricing of these products. In the following,
we present a model which overcomes this lack and incorporates the default risk of the
issuing company in the pricing. We derive closed-form expressions for index, basket,
and bonus certificates under issuer risk in a Black–Scholes model framework. The
results are analyzed for different scenarios and compared with valuations in a model
which neglects issuer risk.
123
124 Götz et al.
6.1. INTRODUCTION
Certificates have become very popular with retail customers in Germany, Austria, and
Switzerland in the last few years. They are referred to as structured products. The
simplest structures are index certificates, which allow a retail customer to invest in
an index like the German stock index Deutscher Aktien Index (DAX) or the Dow
Jones Euro Stoxx 50. From a legal point of view, those products are bonds and the
investors are, thus, creditors of the respective issuer. This rather technical aspect has
been disregarded in the investment decision by many retail investors. Even the value
at risk figures which are sometimes indicated by banks to show the investors the risk
involved in single certificates are based on the assumption of a non-defaultable issuer.
However, in the case of an insolvency of the issuer, the investor may lose his total
investment regardless of the performance of the underlyings of the certificate. The
case of Lehman Brothers shows that this risk can materialize. Certificates differ in this
feature from an investment in funds. The investment in a fund is a so-called special
property and is not affected at all by the rating and creditworthiness of the issuing
company.
Issuer risk is the risk of loss on securities and other tradeable obligations because
the issuer does not fulfil his contractual obligations due to his insolvency. Up to today
this kind of risk has been hardly addressed in the pricing of exotic securities and
especially not from a retailer’s perspective but only in connection with regulatory
capital requirements like in Basel II. More details about modeling and evaluating
counterparty/issuer risk under an economic or regulatory perspective can be found
in [1–3].
Pricing securities under counterparty risk can be traced back to Merton [4]. John-
son and Stulz [5] analyzed the counterparty risk in option pricing. They used a firm
value model and assumed that the vulnerable option presents the single debt of the
company. A huge increase in the derivative’s value, thus, rises the risk of default of
the company. This approach is only appropriate when the derivative is the only or
the predominant source of funding of the counterparty. Hull and White [6] as well as
Jarrow and Turnbull [7] value so-called vulnerable options, options on a bond written
by a defaultable party, in a reduced-form model assuming independence between the
credit risk of the counterparty and the asset underlying the derivative. Cherubini and
Luciano, see [8,9], suggest to use a copula approach to value the counterparty risk in an
investment and to allow for a dependence structure between term-structure movements
and a default of one of the parties.
Klein [10] as well as Klein and Inglis [11] choose a firm-value model to account
for the issuer risk and to model the dependencies between the issuing firm and the
underlying. We follow their approach in that regard, and condition the payoff of the
certificate on the survival of the issuer: the certificate only pays back the total investment
Pricing Certificates Under Issuer Risk 125
and gain as long as the issuer has not defaulted, i.e., its asset value has not fallen under
a certain barrier. Like Klein [10] and Klein and Inglis [11], we model the correlation
between the assets of the issuer and the asset underlying the derivative explicitly.
The barrier is exponentially increasing in time, and the issuer can default, anytime
before maturity. In the case of default, the investor recovers a constant fraction of
the market value of his investment. As we deal with retail products, we furthermore
assume that the exotic structures are fully hedged, i.e., all debt owed to the investor has
to be seen alongside assets which the company owns. In the case of default, however,
these assets do not cover the investors but are part of the insolvency estate. This
allows us to assume the boundary as deterministically increasing rather than stochastic,
see [11].
6.2. THE MODEL
The model formulation is influenced by the CreditGrades framework, for details

see [12, 13]. This approach allows us to derive closed-form expressions for index,
participation guarantee, bonus guarantee, discount, and bonus certificates under issuer
risk in a Black–Scholes framework.
The system of processes is defined on a filtered probability space (, F, F, P).
We assume the existence of an equivalent martingale measure. As an immediate con-
sequence, the market is arbitrage-free. The processes are directly formulated under the
martingale measure Q. We consider an issuing company i = 1 with an asset value per
share at time t of V1,t , an equity price S1,t , and a total debt per share of D1,t . The firm’s
value dynamics follow a geometric Brownian motion
dV1,t
= (rt − d1,t )dt + σ1 dW1 , V1,0 = S1,0 + D1,0 . (6.1)
V1,t
The company’s debt is deterministic and yields a continuous interest of rs − d1,s .
t
D1,t = D1,0 e 0 (rs −d1,s )ds , (6.2)
where rs is the risk-free interest rate and d1,s is the dividend yield on the company’s
assets. Both processes, rs and d1,s , are assumed to be deterministic. The issuing com-
pany defaults if its value falls below the barrier D1,t . Thus, the time of default is defined
by the stopping time τ
τ = inf{t ∈ (t0 , T ] : V1,t < D1,t }. (6.3)
We denote the equity per share by

S1,t = V1,t − D1,t , if τ > t and,
(6.4)
S1,t = 0 otherwise.
126 Götz et al.
This implies that default occurs whenever the stock price S1,t falls to zero. As soon as
S1,t reaches zero, it remains there. In this framework, an European option is seen as
the corresponding down-and-out barrier option with an absorbing barrier for S1,t set
at 0. Hence, an equivalent time to default to τ is
ς = inf{t ∈ (t0 , T ] : S1,t ≤ 0}. (6.5)
The dynamics for S1,t are, prior to default, found by applying Itô to (6.4) and are
given by
dS1,t = S1,t (rt − d1,t )dt + (D1,t + S1,t )σ1 dW1 . (6.6)
The stock price of the issuer follows — prior to default — a shifted log-normal distribu-
tion. This distribution implies negative stock prices with positive probability, see [13]
for more details. The higher the leverage (debt-to-equity ratio), the higher is the prob-
ability of default and vice versa.
The dynamics of the underlying assets of a certificate are modeled by geometric
Brownian motions. The following system is considered to describe the assets of the
issuer and the underlying assets of the derivatives:
dS1,t = S1,t (rt − d1,t )dt + (D1,t + S1,t )σ1 dW1 (6.7)
dSi,t = Si,t (rt − di,t )dt + Si,t σi dWi for i = 2, . . . , n (6.8)
dWi , dWj = ρij dt, for i, j ∈ 1, . . . , n, i = j, −1 ≤ ρij ≤ 1,
where σi and ρij are constants, see [14].
6.3. PRICING OF CERTIFICATES UNDER ISSUER RISK
6.3.1. Building Blocks

The most popular certificates are composed from simple building blocks such as zero-
coupon bonds Zt , investments in an underlying S2,t , call options Ct (S2 , K), and digital
options Cd,t (S2 , K) as well as knock-out put options Pk,t (S2 , K, B). The formulas for
these components are derived for the case that the issuer can default and has a recovery
rate of zero, for a similar model see [15], page 635ff. In the case of no default, the
valuation of the building blocks is well known and will be provided for the purpose
of completeness. By means of these building blocks defaultable index, guarantee, and
bonus certificates can be valued for any assumption of the recovery rate. The proofs
for the results in this section will be provided in the Appendix.
A main component of index certificates and discount certificates is the investment
in the underlying S2 , which is actually worth S2,t at time t, when we assume that the
issuer cannot default.
Proposition 6.1. In the case when the investment in the equity is guaranteed by an
D
issuer who is defaultable with recovery rate zero, the price S2,t of this investment at
time t is given by
D
S2,t = S2D (S1 , S2 , t)
T
= e− t rs ds+ατ+β1 y1 +β2 y2 − 12 χ(δ21 +2ρδ1 δ2 +δ22 )
√
× (e(δ1 ψ1 +δ2 ψ2 ) χ
N2 (ψ1 , z2 , ρ)
√
(δ1 ξ1 +δ2 ξ2 ) χ
−e N2 (ξ1 , z2 , ρ)), (6.9)
where N2 (x, y, ρ) is the standard bivariate normal distribution function with correla-
tion ρ,

S1,t + D1,t T
y1 = ln , y2 = ln(S2,t e t (rs −d2,s )ds ),
D1,t
τ = T − t, χ = σ1 σ2 τ,

σ2 σ1
z1 = y1 , z2 = y2 ,
σ1 σ2
σ1 − ρσ2 σ2 − ρσ1
β1 = , β2 = ,
2σ1 (1 − ρ2 ) 2σ2 (1 − ρ2 )

σ1 σ2
δ1 = − β1 , δ2 = (1 − β2 ),
σ2 σ1
1 σ12 − 2σ1 σ2 ρ + σ22
α=− ,
4 2(1 − ρ2 )
z1 √ z2 √
ψ1 = √ + χ(δ1 + ρδ2 ), ψ2 = √ + χ(δ2 + ρδ1 ),
χ χ
z1 √ 2ρz1 − z2 √
ξ1 = − √ + χ(δ1 + ρδ2 ), ξ2 = − √ + χ(δ2 + ρδ1 ).
χ χ
For a proof see A.1. Products, which ensure a repayment of an investment with
notional 1, are internally stripped into a zero-coupon bond and several derivatives.
T
As known, a non-defaultable zero-coupon bond is priced by Zt = exp(− t rs ds).
Whereas when we assume that the issuer can default and — if he defaults — with no
recovery, the value of the zero-coupon bond can be computed by, see [13]
T
ZtD = e− t rs ds
(N (d3 ) − ex1 N (d4 )), (6.10)
with N (.) being the standard cumulative normal distribution function,

S1,t + D1,t x1 1√ x1 1√
x1 = ln , d3 = √ − χ, d4 = − √ − χ.
D1,t χ 2 χ 2
128 Götz et al.
When the issuer additionally promises a fixed interest rI on the investment this is val-
T
ued, assuming no default, by ZI,t = (1 + rI ) exp(− t rs ds) and accordingly by ZI,tD
=
T
exp(− t rs ds)(1+rI )(N (d3 )−e N (d4 )) in a world with defaults and zero recovery.
x1
Call options are introduced in the structured products to leverage the investment
and to grant the investor a high participation rate in the value of the underlying. If no
default of the issuer is assumed the call option with strike K is priced by the well-
T
known Black–Scholes formula Ct (S2 , K) = S2,t N (d1 ) − K exp(− t rs ds)N (d2 ),
√ √
where d1 = (ln(S2,t /K) + (r + 1/2σ22 )(T − t))/(σ T − t) and d2 = d1 − σ T − t.
Proposition 6.2. The price CtD at time t of a defaultable call option, when the payment
of the call option is guaranteed by an issuer who is defaultable with recovery rate zero,
is given by
T √
CtD (S1 , S2 , K) = Ke− (e− 2 χ(δ1 +2ρδ1 δ2 +δ2 ) (e(δ1 η1 +δ2 η2 )
1 2 2
t rs ds+ατ+β·X χ
N2 (η1 , η2 , ρ)
√
(δ1 ν1 +δ2 ν2 ) χ
−e N2 (ν1 , ν2 , ρ))
√
− 12 χ(δ− − − −2 − − − −
2
−e 1 +2ρδ1 δ2 +δ2 ) (e(δ1 η1 +δ2 η2 ) χ
N2 (η− −
1 , η2 , ρ)
− − √
(δ− −
−e 1 ν1 +δ2 ν2 ) χ N2 (ν1− , ν2− , ρ))), (6.11)
where

S1,t + D1,t S2,t T (rs −d2,s )ds
x1 = ln , x2 = ln et ,
D1,t K

σ2 σ1
z1 = x1 , z2 = x2 ,
σ1 σ2

− σ1 − σ2
δ1 = − β1 , δ2 = − β2 ,
σ2 σ1
z1 √ z2 √
η1 = √ + χ(δ1 + ρδ2 ), η2 = √ + χ(δ2 + ρδ1 ),
χ χ
z1 √ 2ρz1 − z2 √
ν1 = − √ + χ(δ1 + ρδ2 ), ν2 = − √ + χ(δ2 + ρδ1 ),
χ χ
z1 √ − z2 √ −
η−
1 = √ + χ(δ1 + ρδ−
2 ), η−
2 = √ + χ(δ2 + ρδ−
1 ),
χ χ
z1 √ 2ρz1 − z2 √ −
ν1− = − √ + χ(δ− − −
1 + ρδ2 ), ν2 = − √ + χ(δ2 + ρδ−
1 ),
χ χ
for β1 , β2 , δ1 , and δ2 refer to Proposition 6.1.
For a proof see A.2. Similarly, the non-defaultable digital option with strike K is priced
T
by Cd,t (S2 , K) = exp(− t rs ds)N (d2 ).
D
Proposition 6.3. The price Cd,t at time t of a defaultable digital call option where the
payment of one is guaranteed by an issuer who is defaultable with recovery rate zero
is given by
D
Cd,t (S1 , S2 , K)
T √
rs ds+ατ+β1 x1 +β2 x2 − 12 χ(δ− − − − − − − −
2 2
= e− t 1 +2ρδ1 δ2 +δ2 ) (e(δ1 η1 +δ2 η2 ) χ
N2 (η− −
1 , η2 , ρ)
− − − − √
− e(δ1 ν1 +δ2 ν2 ) χ
N2 (ν1− , ν2− , ρ)), (6.12)
with parameters explained in Propositions 6.1 and 6.2.
For a proof see A.3. The bonus certificate includes, beside other derivatives, a knock-
out put option. The price of a non-defaultable knock-out put option with barrier B and
strike K is given by, see also [16],
Pk,t (S1 , S2 , K, B)
2β B S2
−
T B 2 ln − ln

= Pt (S2 , K) − Ke t rs ds
√ − β σ2 (T − t)
N K K
σ2 T − t K
2(β−1) B
T
− t d2 ds B 2 ln K − ln SK2
+ Se N √ + (1 − β )σ2 (T − t) ,
K σ2 T − t
(6.13)
where
T
Pt (S2 , K) = Ke− t rs ds N (−d2 ) − S2,t N (−d1 ),

∗ S2 B
x2 = ln , b = ln ,
K K
1 r − d2 1
β = α = − σ22 β ,
2
− ,
2 σ22 2
χ = σ22 τ
and d1 , d2 as in Proposition 6.2.
D
Proposition 6.4. The price Pk,t at time t of a defaultable knock-out put option, when
the payoff is guaranteed by an issuer who is defaultable with recovery rate zero, is
given by
T ∗ ∗
D
Pk,t (S1 , S2 , K, B) = Ke(− t rs ds+α τ+β1 x1 +β2 x2 )
√ 2 ∗
∗ ∗
× h(τ, z∗1 , z∗2 , y1∗ , y2∗ ) max(e−β1 (σ1 1−ρ y1 +σ1 ρy2 )−β2 (y2 σ2 +b)

√
−β1 (σ1 1−ρ2 y1∗ +σ1 ρy2∗ )+(1−β2 )(y2∗ σ2 +b)
−e , 0)dy2∗ dy1∗ , (6.14)
130 Götz et al.
where

1 x1 x∗ − b x∗ − b
z∗1 = −ρ 2 , z∗2 = 2 ,
1 − ρ2 σ1 σ2 σ2

1
σ σ − ρ 12 σ22 − (r − d2 )
2 1 2 1 σ2 − ρσ1 r − d2
β1 = , β2 = − ,
(1 − ρ )σ1 σ2
2 2 (1 − ρ )σ2
2 (1 − ρ2 )σ22

1 1 2 1 1
α∗ = − σ12 β1 − σ2 − (r − d2 ) β2 + σ12 β1 + σ22 β2 + ρσ1 σ2 β1 β2 .
2 2
2 2 2 2
h(τ, z∗1 , z∗2 , y1∗ , y2∗ ) is given in Appendix A.4.
6.3.2. Index Certificates

In this section, we price an index certificate with price It at time t under issuer risk.
As stated before, the index certificate allows a retail investor to invest in a single stock
or stock index with price S2,t at time t. He fully participates in any movement of the
underlying. The index certificate does not provide any protection against a decline of
the underlying. Internally this certificate is hedged by buying the respective index or
single stock. Taking into consideration the issuer risk and assuming a constant recovery
rate R in the case of default of the issuer, the index certificate can be valued by
T
I(t, S1 , S2 ) = S2,t − (1 − R)e− t rs ds EQ S2,T 1{ς≤T } | Ft , (6.15)
where ς is given in (6.5). The index certificate can be valued by using the building
blocks of Proposition 6.1. Thus, the certificate is priced by the following formula
I (t, S1 , S2 ) = RS2,t + (1 − R) S2,t

D
(S1 , S2 ). (6.16)
The number of parameters rises considerably if the notion of issuer risk is incorporated
in the pricing of derivatives. In the following, we show the results of the valuation of
the index certificate in different scenarios. The results are compared to prices which
neglect issuer risk. For all the scenario computations in this chapter, we have chosen
the following instrument parameterizations if not stated differently in the respective
examples:
• Stock prices of the issuer and the underlying S1 = S2 = 100 in t = 0

• Volatilities of issuer and underlying σ1 = σ2 = 0.4
• Correlation between underlying and issuer ρ = 0.3
• Risk-free rate of return r = 0.04
• Recovery rate R = 0.4
• Debt endowment D0 = 50 in t = 0
• Maturity of the respective options T = 4
Index certificate
110
Defaultable
Non-defaultable
100
90
80
Value
70
60
50
40
0 200 400 600 800 1000 1200
Debt level
Figure 6.1 Impact of debt.
Figure 6.1 shows that for increasing debt of the issuing company the value of the index
certificate declines and finally approaches RS2,t . The price of the non-defaultable cer-
tificate stays at par regardless of the debt level. This shows that for a retail investor a
simple comparison of the prices of index certificates of different issuers is not appropri-
ate in order to find the security with the best price-performance ratio. For his investment
decision, the investor has to take the rating and equity to debt ratio into consideration.
In Fig. 6.2, the impact of the volatility of the issuer’s asset (the volatility of
the underlying is kept to 0.4) and the correlation between the issuer’s asset and the
underlying is analyzed. For that reason, we choose a relatively low debt scenario. The
negative relationship between the volatility of the issuer’s assets and the price is clearly
visible. The probability of a default considerably increases in high volatility scenarios
and thus the price decreases. It strikes that the impact of the correlation on the price
grows with the volatility: for a very high volatility, a correlation near 1 leads to a
considerably higher value than a correlation near −1. In a low volatility and low debt
scenario with D0 = 50, the price is not much affected by the level of the correlation
as the probability of default is relatively low. However, in a high volatility and low
debt scenario with, thus, higher probability of default of the issuer, both assets tend
to move in the same direction if the correlation rises. Thus, in contrast to a negative
correlation, the probability that the issuer survives and the underlying asset features
a positive return goes up. A negative correlation results in a different performance of
132 Götz et al.
Index certificate
100
90
80
Value
70
60
50
1
40
0.7 0.5
0.6 0
0.5
0.4 −0.5
0.3
0.2 −1
Volatility S1 Correlation
Figure 6.2 Impact of volatility and correlation.
the issuer’s assets and the underlying. Thus, the probability goes up that the certificate
matures at a low value or worthless.
6.3.3. Participation Guarantee Certificates

In contrast to the index certificate, the participation guarantee certificate offers the
investor some risk protection against a decrease of the underlying. However, this pro-
tection is financed by a limited profit in cases when the underlying increases. The
investor participates in any positive performance of the underlying on the basis of the
so-called participation rate. This structure is built up by long positions in a zero-coupon
bond with a standardized notional of 1 and stock options whereas the number of stock
options is determined by the level of the participation rate. Taking into consideration
the issuer risk, the price is indicated by
T
PG(t, S1 , S2 ) = e− t rs ds
(EQ [(1 + p max[S2,T − K, 0]) | Ft ]
− (1 − R)EQ [(1 + p max[S2,T − K, 0])1{ς≤T } | Ft ]), (6.17)
where ς is as described in (6.5), p is the participation rate of the contract, and K

describes the price level where the participation starts. This means that below this
point the investor does not profit from any increase in the stock price. A defaultable
participation guarantee certificate of an issuer with recovery rate R is, thus, priced by
PG(t, S1 , S2 ) = R(Zt + pCt (S2 , K))
+ (1 − R)(ZtD (S2 ) + pCtD (S1 , S2 , K)). (6.18)
For the participation guarantee certificate, we compute some scenario values. For these
computations, we choose a notional of 88, a start of the participation of K = 100, and
a participation rate of p = 50%.
In Fig. 6.3, we find the impact of the debt level on the participation guarantee
certificate similar to that of the index certificate: as before the price falls especially
steeply for smaller D0 levels.
In Fig. 6.4, the joint impact of the issuer’s volatility and the correlation is shown.
The form of the graphs resembles the graph of Fig. 6.2 and the same explanations
apply to explain the form. The effect of the correlation on the price of the participation
guarantee certificate is, however, clearly less distinct because the total price of the
certificate considerably depends on the value of the zero-coupon bond for which the
correlation is irrelevant.
Participation guarantee certificate

100
Defaultable
Non-defaultable
90
80
Value
70
60
50
40
0 200 400 600 800 1000 1200
Debt level

134 Götz et al.
Participation guarantee certificate
95
90
85
80
Value
75
70
65
60 1
0.7 0.5
0.6 0
0.5
0.4 −0.5
0.3
0.2 −1
6.3.4. Bonus Guarantee Certificates

When investing in a bonus guarantee certificate, one does not directly participate in
fluctuations of the value of the underlying. Rather, one receives a fixed interest rate and
additionally a bonus payment if the underlying is above the bonus barrier at maturity.
The investor could compose this payoff by buying a zero-coupon bond and a digital
option:
T
BG(t, S1 , S2 ) = e− t rs ds
(EQ [(1 + rI + 1{S2,T >K} ) | Ft ]
− (1 − R)EQ [(1 + rI + 1{S2,T >K} )1{ς≤T } | Ft ]), (6.19)
where ς is as in (6.5), rI the basic interest, the bonus payment rate described in
the contract, and K the bonus barrier. In our framework, the risk–neutral price of the
bonus guarantee certificate is given by
BG(t, S1 , S2 ) = R(ZI,t + Cd,t (S2 , K))
+ (1 − R)(ZI,t
D
(S2 ) + Cd,t
D
(S1 , S2 , K)). (6.20)
To show the impact of debt, volatility, and correlation, we structure a bonus guarantee
certificate with notional 88, bonus barrier K = 120, basic interest rI = 3.0%, and
bonus payment rate = 3.4%.
Bonus guarantee certificate

80
Defaultable
75 Non-defaultable
70
65
60
Value
55
50
45
40
35
30
0 200 400 600 800 1000 1200
Debt level
For the bonus guarantee certificate, we observe the same typical feature of the
graph, which shows prices for different debt levels, see Fig. 6.5, as for the other
examples: the graph decreases sharply for lower debt levels and approaches R times
the price of the analogous certificate of a non-defaultable issuer.
In Fig. 6.6 the relationship between price and volatility is of nearly linear kind:
the higher the volatility, the lower the price the investor has to pay. The impact of the
correlation is less distinct as in the case of index certificates due to the fact that a major
part of the value of the bonus guarantee depends on the zero-coupon bond.
6.3.5. Discount Certificates

The risk protection of a discount certificate consists in a risk buffer: the investor buys
the certificate at a discount on the actual value of the underlying. This risk limitation
is again financed by a gain limit. The structure can be hedged by investing in the
underlying and writing a call option, i.e., the value is specified by
T
DC(t, S1 , S2 ) = S2,t − Ct (S2 , K) − (1 − R)e− t rs ds

× EQ S2,T − max[S2,T − K, 0] 1{ς≤T } | Ft , (6.21)
136 Götz et al.
Bonus guarantee certificate
75
70
Value
65
60 1
0.5
55 0
0.7
0.6 −0.5
0.5
0.4
0.3 −1 Correlation
0.2
Volatility S1
where ς is as in (6.5). The discount certificate can be valued by the following formula
DC(t, S1 , S2 ) = R(S2,t − Ct (S2 , K))

+ (1 − R)(S2,t
D
(S1 , S2 ) − CtD (S1 , S2 , K)). (6.22)
We value a discount certificate with K = 120 in different scenarios.

With respect to the debt level, the value of the discount certificate does not differ
in its characteristics from the certificates analyzed before, see Fig. 6.7.
In Fig. 6.8, we look into the dependence of the price on the issuer’s volatility and
the correlation. Regarding the volatility, we see the known structure, i.e., the price falls
when the volatility increases. The slopes are similar for all correlation scenarios. As the
certificate consists of building blocks clearly dependent on the correlation, the impact of
the correlation on the value of the certificate is similar to the index certificate example.
6.3.6. Bonus Certificates

The investor in this certificate is protected from a decline of the underlying up to a
certain point, the protection barrier B. Below this point, the investor fully participates
in any fluctuations of the underlying. The same is true for the performance of the
underlying beyond the bonus barrier K. The certificate can be fully hedged by an
Discount certificate
75
Defaultable
70 Non-defaultable
65
60
55
Value
50
45
40
35
30
0 200 400 600 800 1000 1200
Debt level
Discount certificate
75
70
65
60
Value
55
50
45
40
1
35
0.7 0.5
0.6 0
0.5
0.4 −0.5
0.3
0.2 −1

138 Götz et al.
investment in the underlying and by buying a knock-out put option. The respective
barrier level is the protection barrier. When the issuer risk is incorporated in the pricing
model, the price is specified by
BC(t, S1 , S2 )
T
= S2,t + e− t rs ds
EQ [max[K − S2,T , 0]1{τ2 >T } | Ft ]
T
− (1 − R)e− t rs ds
EQ [(S2,T + max[K − S2,T , 0]1{τ2 >T } )1{ς≤T } | Ft ], (6.23)
where
τ2 = inf(t ∈ (t0 , T ] : S2,t ≤ B), (6.24)
where ς is as in (6.5). The following formula evaluates the payoff:
BC(t, S1 , S2 ) = R(S2,t + Pk,t (S2 , K, B))
D
+ (1 − R) S2,t (S1 , S2 ) + Pk,t
D
(S1 , S2 , K, B) . (6.25)
Finally, we show some exemplary computations of the bonus certificate. We assumed
a protection barrier B = 80 and a bonus barrier K = 120 for our computations.
Not surprisingly, the graph, i.e., Fig. 6.9, plotting the debt level of the issuer against
the value of the bonus certificates shows the same features as in the examples above.
Bonus certificate
110
Defaultable
Non-defaultable
100
90
80
Value
70
60
50
40
0 200 400 600 800 1000 1200
Debt level

Bonus certificate
100
90
80
70
Value
60
50
40 1
0.5
30 0
2.5
2 1.5 −0.5
1
0.5
0 −1
Correlation
Volatility S1
In Fig. 6.10, we see a strong impact of correlation in high volatility scenarios and
small influence in lower volatility scenarios. These characteristics can be explained by
the fact that correlation between issuer and underlying has a considerable impact on
the price of the building blocks of the bonus certificate.
6.4. CONCLUSION
We have derived closed-form expressions for index, discount, participation guarantee,

and bonus certificates under issuer risk in a Black–Scholes model framework. Our
scenario computations clearly depict that, depending on the issuer’s capital soundness,
a pricing formula which neglects issuer risk considerably overprices the value of the
singular certificate. Thus, for a retail investor, a simple comparison of the prices of
certificates of different issuers is not appropriate in order to find the security with the
best price-performance ratio. For his investment decision, the investor has to take the
rating and equity to debt ratio into consideration.
140 Götz et al.
A.1. PROOF OF PROPOSITION 6.1
D
Proof. S2,t fulfils the following partial differential equation and boundary conditions

 1 2 ∂2 S2,t
D
1 ∂2 S2,t
D
∂2 S2,t
D

 σ1 (S1 + D1,t )2 + σ22 S22 + ρσ1 σ2 (S1 + D1,t )S2

 2 2


2 ∂S1 2 ∂S2 ∂S1 ∂S2


 D
∂S2,t D
∂S2,t D
∂S2,t
+ (rt − d1,t )S1 + (rt − d2,t )S2 + − rt S2,t
D
= 0,

 ∂S 1 ∂S2 ∂t




S2 (t, 0, S2 ) = 0,
D


 D
S2 (T, S1 , S2 ) = S2,T .
By introducing, the following transformations

T
S2D (t, S1 , S2 ) = e− t rs ds ατ+β1 y1 +β2 y2 D∗
e S2 (t, y1 , y2 ),
τ = T − t, χ = σ1 σ2 τ,

S1,t + D1,t
y1 = ln ,
D1,t
T
y2 = ln (S2,t e t (rs −d2,s )ds ),

σ2 σ1
z1 = y1 , z2 = y2 ,
σ1 σ2
1 σ1 − ρσ2 1 σ2 − ρσ1
β1 = , β2 = ,
2 (1 − ρ2 )σ1 2 (1 − ρ2 )σ2
1 σ12 − 2σ1 σ2 ρ + σ22
α=− ,
4 2(1 − ρ2 )
the PDE can be reduced to

 D∗

 ∂S 1 ∂2 S2D∗ 1 ∂2 S2D∗ ∂2 S2D∗
 2 −
 − − ρ = 0,

 ∂χ 2 ∂z21 2 ∂z22 ∂z1 ∂z2
S2 (χ, 0, z2 ) = 0,
D∗ (A.1)





S D∗ (0, z , z ) = (e−β1 σ12 z1 +(1−β2 ) σ21 z2 ).
σ σ
2 1 2
This problem can be rewritten in terms of its transition probability density

p(χ, z1 , z2 , z1 , z2 ). p(χ, z1 , z2 , z1 , z2 ) is a fundamental solution of the partial dif-
ferential equation above and satisfies the backward Kolmogorov equation, see
[17], page 368f, with initial condition p(0, z1 , z2 , z1 , z2 ) = δ(z1 − z1 )δ(z2 − z2 ),
see [15], page 493. We apply the method of images, see [18], page 476ff, to restrict the
fundamental solution to the area the problem is defined for. This method is appropriate
when the region to which the solution should be bounded is highly symmetric: a solu-
tion for the free space is first derived (pF (χ, z1 , z2 , z1 , z2 )) and then restricted to the
defined region via symmetry, i.e., the principle of reflection. In this case, the image
point (z1 , z2 ) of the source point (z1 , z2 ) is given by
(z1 , z2 ) = (−z1 , −2ρz1 + z2 ).
Thus, the solution is found by
p(χ, z1 , z2 , z1 , z2 ) = pF (χ, z1 − z1 , z2 − z2 )
− pF (χ, z1 + z1 , z2 + 2ρz1 − z2 ).
In this case the solution for the free space is
2
(z +z −2ρz1 z2 ) 2
1 − 1 2
pF (χ, z1 , z2 , z1 , z2 ) = e 2(1−ρ2 )χ .
2π 1 − ρ2 χ
The solution of the original Dirichlet problem can be found by computing, see [17],
page 364ff,
S2D∗ (χ, z1 , z2 )
∞ ∞
σ1

σ2
−β1 z +(1−β2 ) z
= p (χ, z1 −
F
z1 , z2 − z2 )e σ2 1 σ1 2
dz1 dz2
−∞ 0
∞ ∞
σ1

σ2
−β1 z +(1−β2 ) z
− pF (χ, z1 + z1 , z2 + 2ρz1 − z2 )e σ2 1 σ1 2
dz1 dz2 .
−∞ 0
With
∞ ∞

ϕ= pF (χ, z1 , z2 )ek1 z1 +k2 z2 dz1 dz2
−∞ 0
χ(k12 +2ρk1 k2 +k22 ) √

=e 2 lim N2 ( χ(k1 + ρk2 ), z2 , ρ),
z2 →∞
we get Proposition 6.1.
Proof. The proof is similar to the one for the investment in the underlying. By the
means of the Feyman Kac Theorem, see [19], page 143ff, the following PDE can be
142 Götz et al.
derived:
 2 D
 1 2 2∂ C 1 2 2 ∂2 CD ∂2 C D

 σ (S + D ) + σ S + ρσ σ (S + D )S

 2 1 1 1,t
∂S12 2 2 2
∂S22
1 2 1 1,t 2
∂S1 ∂S2




 ∂CD ∂CD ∂CD
+ (rt − D1,t )S1 + (rt − d2,t )S2 + − rt C D = 0,


∂S1 ∂S 2 ∂t



 C (t, 0, S2 ) = 0,
D



 D
C (T, S1 , S2 ) = max(S2 − K, 0).
By applying the transformations, which have been introduced before the PDE can be
reduced to
 D∗ ∗ ∗ ∗

 ∂C 1 ∂2 C D 1 ∂2 CD ∂2 C D

 − − − ρ = 0,

 ∂χ 2 ∂z21 2 ∂z22 ∂z1 ∂z2

∗
CD (χ, 0, z2 ) = 0,






 D∗ σ σ
−β1 σ1 z1 +(1−β2 ) σ2 z2
σ σ
−β1 σ1 z1 −β2 σ2 z2
C (0, z1 , z2 ) = max(e 2 1 −e 2 1 , 0).
Using the method of images on the probability density function as before the solution
is given by
∗
CD (χ, z1 , z2 )
∞ ∞
σ1

σ2
−β1 z +(1−β2 ) z
= pF (χ, z1 − z1 , z2 − z2 )e σ2 1 σ1 2
dz1 dz2
0 0
∞ ∞
σ1

σ2
−β1 z −β2 z
− p (χ, z1 −
F
z1 , z2 − z2 )e σ2 1 σ1 2
dz1 dz2
0 0
∞ ∞
σ1

σ2
−β1 z +(1−β2 ) z
− p (χ, z1 +
F
z1 , z2 + 2ρz1 − z2 )e σ2 1 σ1 2
dz1 dz2
0 0
∞ ∞
σ1

σ2
−β1 σ2 z1 −β2 σ1 z2
− pF (χ, z1 + z1 , z2 + 2ρz1 − z2 )e dz1 dz2
0 0
with
∞ ∞

ϕ= pF (χ, z1 , z2 )ek1 z1 +k2 z2 dz1 dz2
0 0
χ(k12 +2ρk1 k2 +k22 ) √ √

=e 2 N2 ( χ(k1 + ρk2 ), χ(k2 + ρk1 )).
Proof. The PDE and the boundary conditions can be indicated by

 2 D
 1 2 2 ∂ Cd 1 2 2 ∂2 CdD ∂2 CdD

 σ (S + D ) + σ S + ρσ σ (S + D )S

 2 1 1 1,t
∂S12 2 2 2 2
∂S2
1 2 1 1,t 2
∂S1 ∂S2




 ∂CD ∂CD ∂CD
+ (rt − d1,t )S1 d + (rt − d2,t )S2 d + d − rt CdD = 0,


∂S1 ∂S2 ∂t



 CdD (t, 0, S2 ) = 0,




CdD (T, S1 , S2 > K) = 1.
Applying the introduced transformations and using the method of images on the trans-
formed probability density function, one gets
∗
CdD (χ, z1 , z2 )
∞ ∞
1 −β1
σ1
σ2 z1 −β2
σ2
σ1 z2
= pF (χ, z1 − z1 , z2 − z2 )e dz1 dz2
K 0 0
∞ ∞
σ1

σ2

−β1 z −β2 z
− p (χ, z1 +
F
z1 , z2 + 2ρz1 − z2 )e σ2 1 σ1 2
dz1 dz2 .
0 0
Proof. The barrier option can be denoted by

T
PkD (t, S1 , S2 ) = EQ e− t rs ds max[K − S2,t , 0]1{τ2 >T } 1{τ1 >T } | Ft .
The PDE and boundary conditions are given by


 1 ∂2 BPkD 1 2 2 ∂2 PkD ∂2 PkD
 σ12 (S1 + D1,t )2
 + σ S + ρσ σ (S + D )S

 2 ∂S12 2 2 2 ∂S22
1 2 1 1,t 2
∂S1 ∂S2





 ∂P D
∂P D
∂P D

 + (rt − d1,t )S1 k + (rt − d2,t )S2 k + k − rt PkD = 0,
∂S1 ∂S2 ∂t



PkD (t, 0, S2 ) = 0,





PkD (t, S1 , B) = 0,


 D
Pk (T, S1 , S2 ) = max(K − S2 , 0).
144 Götz et al.
Introducing the following transformations

T
rs ds α∗ τ+β1 x1 +β2 x2∗ ∗
PkD (t, S1 , S2 ) = Ke− t e PkD (t, x1 , x2∗ ),

1 1 1 1
α∗ = − σ12 β1 − σ22 − (r − d2 ) β2 + σ12 β1 + σ22 β2 + ρσ1 σ2 β1 β2 ,
2 2
2 2 2 2
S1 + D1,t S2
x1 = ln x2∗ = ln ,
D1,t K
B
τ = T − t, b = ln ,
K

1 x1 x∗ − b x2∗ − b
z∗1 = −ρ 2 , z∗2 = ,
1 − ρ2 σ1 σ2 σ2

1
σ σ − ρ 12 σ22 − (r − d2 )
2 1 2 1 σ2 − ρσ1 r − d2
β1 = , β2 = − 2 ,
(1 − ρ2 )σ1 σ2 2 (1 − ρ )σ2
2 σ2 (1 − ρ2 )
the PDE can be reduced to
 ∗ ∗ ∗

 1 ∂2 PkD 1 ∂2 PkD ∂PkD
 −
 2 ∂z2 − + = 0,

 2 ∂z22 ∂τ


1

 D∗ ∗

Pk (τ, z1 , 0) = 0,




D∗ ∗ 1 − ρ2 ∗
 Pk τ, z1 , − z1 = 0,

 ρ

 √



 P D∗
(0, z ∗ ∗
, z ) = max(e −β1 (σ1 1−ρ2 z∗1 +σ1 ρz∗2 )−β2 (z∗2 σ2 +b)

 k 1 2



 √ 2∗
 ∗ ∗
− e−β1 (σ1 1−ρ z1 +σ1 ρz2 )+(1−β2 )(z2 σ2 +b) , 0).
This PDE can be solved by integrating the payoff over the probability density function,
see [16]
√
∗ 2 ∗ ∗ ∗
PkD (τ, z∗1 , z∗2 ) = h(τ, z∗1 , z∗2 , y1∗ , y2∗ ) max(e−β1 (σ1 1−ρ y1 +σ1 ρy2 )−β2 (y2 σ2 +b)

√
1−ρ2 y1∗ +σ1 ρy2∗ )+(1−β2 )(y2∗ σ2 +b)
− e−β1 (σ1 , 0)dy2∗ dy1∗ ,
where
∞
2 − (q2 +qt2 ) nπθt nπθ q q
h(τ, z∗1 , z∗2 , y1∗ , y2∗ ) =
t
e 2τ sin sin I nπϕ ,
ϕτ n=1 ϕ ϕ τ

1 − ρ2
tan ϕ = − , ϕ ∈ [0, π],
ρ
y2∗
tan θ = , θ ∈ [0, ϕ],
y1∗
z∗2
tan θt = , θt ∈ [0, ϕ],
z∗1

q = y∗1 2 + y∗2 2 ,

qt = z∗1 2 + z∗2 2 .
While the region is given as follow:



 1 − ρ2 ∗

 (−∞, 0) × −∞, − y1 ∪ (0, +∞) if {ρ > 0} ∩ {y1∗ > 0}

 ρ






 1 − ρ2 ∗

 (−∞, 0) × − y1 , +∞ ∪ (−∞, 0) if {ρ > 0} ∩ {y1∗ < 0}

 ρ
=


 1 − ρ2 ∗

 (0, +∞) × 0, − if {ρ < 0} ∩ {y1∗ > 0}

 y1

 ρ






 (−∞, 0) × − 1 − ρ 2

 y1∗ , 0 if {ρ < 0} ∩ y1∗ < 0 ,
ρ
where 0 denotes the values in t. The region is obtained

from the relationships
arctan(y2∗ /y1∗ ) ∈ [0, arctan(− 1 − ρ2 /ρ)] and arctan(− 1 − ρ2 /ρ) ∈ [0, π].
References
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ASSET ALLOCATION WITH CREDIT

INSTRUMENTS
7
BARBARA MENZINGER∗,‡ , ANNA SCHLÖSSER∗,§
and RUDI ZAGST†,¶
∗
risklab GmbH, Seidlstr. 24-24a, 80335 Munich, Germany
†
Technische Universität München,
Parkring II, 85748 Garching, Germany
‡
barbara.menzinger@risklab.com
§
anna.schloesser@risklab.com
¶
zagst@tum.de
This chapter presents a consistent, scenario-based asset allocation framework for

analyzing traditional financial instruments and credit instruments in a portfolio
context. Our framework accounts for the distinct return characteristics of credit instru-
ments by incorporating potential defaults into the total return calculation. We gen-
erate correlated default times with a Normal Inverse Gaussian one-factor copula.
To determine optimal portfolios, we use a mean-variance and a conditional value
at risk optimization. Performing a case study for the U.S. market, we find that the
mean-variance optimization overestimates the benefits of low-rated credit instru-
ments. Though, optimal portfolios always contain a considerable proportion of credit
instruments.
147
148 Menzinger et al.
7.1. INTRODUCTION
The credit market experienced an enormous growth over the last years. As part of
the credit market, the credit derivatives market was the worldwide fastest-growing
derivatives market (see [1]). The market size expanded from USD 180 billion in
1996 via USD 5,021 billion in 2004 to USD 20,207 billion in 2006 and to esti-
mated USD 33,120 billion in 2008 (see [2]). Due to the financial crisis, the growth
was rapidly stopped in 2008 and turned into a decline of the market size. Still, the
actual notional amount outstanding of the credit default swaps (CDS), which are the
most important instruments in this market, exceeded the estimation of the British
Bankers’ Association by far with a notional amount outstanding of USD 41,868 bil-
lion (see [3]). After a standardization of credit derivative contracts and the introduction
of CDS indices, a revolution in terms of liquidity has taken place, which is only one
reason why credit instruments are very attractive to investors. In addition, credit instru-
ments such as corporate bonds, credit derivatives, and securitizations often have an
appealing risk–return profile allowing to enhance the portfolio return. Furthermore,
due to the correlation structure of their returns to those of traditional asset classes
such as stocks and government bonds, they offer high potential for diversification.
Finally, they allow to manage the credit risk exposure. Even knowing the potential
benefits of different credit instruments, investors still have to know how to com-
bine them optimally with traditional asset classes, i.e., they have to decide on the
optimal proportion of credit-related products, especially for their individual level of
risk–aversion.
A reasonable asset allocation including credit instruments needs to account for
the distinct return characteristics of these instruments. We exemplarily analyze the
return properties of daily log-returns of U.S. Lehman aggregates over the period from
7 November, 2002 to 29 September, 2006. The descriptive statistics of the returns
are summarized in Table 7.1, where it becomes obvious that the risk–return profile of
credit instruments cannot be sufficiently described by mean and variance alone.
Table 7.1 Descriptive Statistics of U.S. Lehman Aggregates.
No. of Mean Volatility Excess

U.S. aggregate issuers (Ann.) (Ann.) Skewness kurtosis
Aaa 3560 3.50% 3.27% −0.1310 1.7812

Aa 759 4.23% 4.18% −0.2944 1.5802
A 1404 5.30% 4.55% −0.1787 1.4967
Baa 1215 6.99% 4.72% −0.0508 1.3991
Corporates 2721 5.65% 4.55% −0.1979 1.2648
Asset Allocation with Credit Instruments 149
We observe negatively skewed return distributions and positive excess kurtosis

indicating non-normal distribution of return data. This is confirmed by Jarque–Bera
tests for normality. The non-normality might be attributed to defaults within the
aggregates. The logical consequence is that the shape of the return distributions should
be considered in a realistic asset allocation framework.
In this chapter, we propose a consistent, scenario-based asset allocation framework
that is composed of a simulation, a total return calculation, and an optimiza-
tion. With the simulation framework, we produce consistent capital-market sce-
narios for interest rates, credit spreads, and returns of equity indices, on the one
hand, and correlated default times, on the other hand. For the scenario genera-
tion, we use the four-factor model according to [4] and the model suggested by
[5]. To generate non-normal return distributions of credit instruments, we simu-
late correlated default times for issuers with different ratings. In this context, the
one-factor copula approach for modeling correlated default times between refer-
ence entities has become very popular. We use this approach for a Normal-Inverse-
Gaussian (NIG) one-factor copula as suggested by [6] since it is able to produce
more realistic properties for default times than the wide-spread Gaussian version,
e.g., a higher probability of joint defaults of different companies. This property can
be predominantly observed during a crisis. Then the probability of joint defaults
increases and the value of a portfolio of credit instruments can decrease tremen-
dously, as recently seen during the sub-prime crisis. Therefore, it is particularly
important that events having a large impact on the portfolio value are modeled
realistically.
After having determined the return distribution of the government bonds, the
equity index, and the credit instruments, we are able to calculate optimal asset allo-
cations according to different optimization criteria. We do not only apply traditional
mean-variance portfolio optimization according to [7] but also conditional value at
risk (CVaR) optimization. The latter is more appropriate to capture the distinct distri-
butional properties of credit instruments as it takes into account the left tail of a return
distribution. We perform a case study, applying the asset allocation framework to the
U.S. market. So we can show that investors benefit from adding credit-related products
to their portfolio, i.e., with the same level of risk they can generate a higher expected
return.
This chapter is organized as follows. The second section describes the simulation
framework for the risk factors and the correlated default times. In the third section, we
give the general conditions for the total return calculations. In particular, we explain the
pricing of funded CDS and funded CDS indices. The applied optimization framework
is presented in the fourth section. In the fifth section, we provide the model parameters
and present the simulation and optimization results. We close in the last section with
a summary of the main results.
7.2. SIMULATION FRAMEWORK
The simulation framework consists of a model to simulate risk factors on the one hand
and correlated default times on the other hand.
First, we introduce a model to simulate risk factors. We simulate the short rate,
the growth rate of the Gross Domestic Product (GDP), and the short-rate spread
with the extended model of Schmid and Zagst (see [4]). The short inflation and
the returns of an equity index are simulated with the integrated market model sug-
gested by [5]. The latter can be embedded into the extended model of Schmid and
Zagst.
In the following, we assume that markets are frictionless and perfectly competi-
tive, that trading takes place continuously, that there are neither taxes nor transaction
costs or informational asymmetries, and that investors act as price takers. We fix a
terminal time horizon T ∗ . Uncertainty in the financial market is modeled by a com-
plete probability space (, G, P) and all random variables and stochastic processes
introduced below are defined on this probability space. We assume that (, G, P) is
equipped with three filtrations H, F, and G, i.e., three increasing families of sub-
σ-fields of G. The default time τ of an obligor is an arbitrary non-negative random
variable on (, G, P). For the sake of convenience, we assume that P[τ = 0] = 0
and P[τ > t] > 0 for every t ∈ (0, T ∗ ]. For a given default time τ, we introduce
the associated default indicator or hazard function H(t) = 1{τ≤t} , t ∈ (0, T ∗ ]. Let
H = (Ht )0≤t≤T ∗ be the filtration generated by the process H. In addition, we define
the filtration F = (Ft )0≤t≤T ∗ as the filtration generated by the multi-dimensional
standard Brownian motion Wt = (Wr,t , Wω,t , Wu,t , Ws,t ) and G = (Gt )0≤t≤T ∗ as
the enlarged filtration G = H ∨ F, i.e., for every t we set Gt = Ht ∨Ft . All
filtrations are assumed to satisfy the usual conditions of completeness and right-
continuity. For the sake of simplicity, we furthermore assume that F0 is trivial. It
should be emphasized that τ is not necessarily a stopping time with respect to the
filtration F but of course with respect to the filtration G. If we assumed that τ
was a stopping time with respect to F, then it would be necessarily a predictable
stopping time.
We assume that there exists a measure Q ∼ P such that all discounted price
processes of the financial instruments are martingales
t
relative to (Q, G).As numéraires,
we choose the money-market account Bt = e 0 rl dl with rt denoting the non-defaultable
short rate. We will assume throughout the chapter that for any t ∈ (0, T ∗ ] the σ-fields
FT ∗ and Ht are conditionally independent (under Q) given Ft . Following [8], p. 167
and p. 242, this is equivalent to the assumption that for any t ∈ (0, T ∗ ] and any Q-
integrable FT ∗ -measurable random variable X, we have EQ [X | Gt ] = EQ [X | Ft ].
We start by defining all processes under the real-world measure P and will then work
under the equivalent martingale measure Q.
The dynamics of the non-defaultable nominal short rate r is described by a

two-factor Hull–White model and is given by
drt = (θr,t + br ωt − ar rt )dt + σr dWr,t , (7.1)
dωt = (θω − aω ωt )dt + σω dWω,t , (7.2)
where ar , br , σr , aω , and σω are positive constants, θω is a non-negative constant, θr,t is
a continuous, deterministic Nelson–Siegel function that fits the market term structure
at simulation start date. (For details see, for example, [9, 10].) dWr,t and dWω,t are
independent standard Brownian motions. ω represents the GDP growth rate so that the
interest-rate levels directly depend on general economic conditions. The dynamics of
the short-rate spread are described by
dst = [θs + bsu ut − bsω ωt − as st ]dt + σs dWs,t , (7.3)
dut = [θu − au ut ]dt + σu dWu,t , (7.4)
where bsu , bsω , as , σs , au , and σu are positive constants, θs , θu are non-negative con-
stants and dWu,t , dWs,t are independent standard Brownian motions. u is the so-called
uncertainty index and can be interpreted as an aggregation of all available information
about the quality of the firm, i.e., it represents the firm-specific risk. The higher its
value, the lower the firm’s quality. The GDP behaves reversely. If it grows at a higher
rate, spreads usually tighten as the probability of default of a firm becomes smaller.
We need the dynamics of the short inflation i for the modeling of the equity-return. It
is given by
dit = (θi − ai it )dt + σi dWi,t , (7.5)
where ai and σi are positive constants, θi is a non-negative constant and dWi,t is a
standard Brownian motion. Then the continuous return of an equity index RE,t is
described by
dRE,t = [αE + bEω ωt − bEi it + bER rt ]dt + σE dWE,t , (7.6)
where αE ∈ R, bEω , bEi , bER , and σE are positive constants and dWE,t is a standard
Brownian motion. Note that this process reflects the so-called “stock return-inflation
puzzle” stating that inflation negatively influences stock returns (see for example
[11]– [15]).
So far, we considered the dynamics of the SDEs in Eqs. (7.1)–(7.4) under the
real-world measure P. Though, as we are interested in zero-coupon bond prices as
well as interest rates and credit spreads for different terms, we need to know the
parameters of the SDEs under the risk–neutral equivalent martingale measure Q.
Replacing ar , aω , as , au by âr , âω , âs , âu and using independent standard Brownian
motions d Ŵr,t , d Ŵω,t , d Ŵs,t , d Ŵu,t instead of dWr,t , dWω,t , dWs,t , dWu,t , leads to the
processes under this measure. The relationship between the parameters is given by
âk = ak + λk σk2 , where k = r, ω, s, u. We obtain λr , λω , λs , λu when changing measure
from P to Q by applying Girsanov’s Theorem (see, for example, [4]).
The processes introduced earlier imply analytical formulas for the zero rates at
time t to maturity T of non-defaultable and defaultable bonds, R(t, T ) and Rd (t, T ),
as well as for the credit spreads, S(t, T ). So, we can determine the complete term
structure. The explicit formulas can be found in the Appendix.
To simulate correlated default times, we use Li’s approach, who presents an effi-
cient algorithm in [16]. We use it with a one-factor copula as applied for example
by [17]. The one-factor copula is a simple, but powerful way to quickly define a corre-
lation structure between several variables. Therefore, it has become very popular and
the standard approach in practice to simulate correlated default times. The underlying
idea is the following: In reality, more firms default during a recession than during a
booming period. This implies that each firm is subject to the same set of macroeco-
nomic environment and that there exists a dependence among the firms. The Gaussian
one-factor copula is often applied due to an easy implementation and the appealing
properties of a standard normal distribution, such as the stability under convolution.
We rather use the NIG copula which is able to overcome some modeling deficiencies
of the Gaussian copula, e.g., the lack of tail dependence. The NIG distribution is a
mixture of normal and inverse Gaussian distributions. It is a four parameter distribu-
tion with very interesting properties. It can produce fat tails and skewness, it is stable
under convolution (under certain conditions), and the density function, the distribution
function and the inverse distribution function can be computed sufficiently fast (see [6]
and [18]). A definition of the NIG distribution and its most important properties can
be found in [6].
Before presenting the copula model, we explain the idea of the Large Homoge-
neous Portfolio (LHP) approach, introduced by [19]. It assumes a constant default
correlation structure over the reference credit portfolio, with the same default prob-
abilities and the same recovery rate in case of default, and it models default using
a one-factor Gaussian copula. Reference [6] modified the LHP model by replacing
the Gaussian distribution with the NIG distribution. Their one-factor copula model is
briefly introduced in the following.
Consider a homogeneous portfolio of m credit instruments. The standardized asset
return of the i-th issuer in the portfolio, Ai , is assumed to be of the form

Ai = aM + 1 − a2 Xi (7.7)
with independent random variables

βγ 2 γ 3
M ∼ N IG α, β, − 2 , 2 , (7.8)
α α
and
√ √ √ √
1 − a2 1 − a2 1 − a2 βγ 2 1 − a2 γ 3
Xi ∼ N IG α, β, − , , (7.9)
a a a α2 a α2

where γ = α2 − β2 .
Then, the asset returns Ai also follow an NIG distribution with the parameters

α β βγ 2 γ 3
Ai ∼ N IG , , − 2 , 2 =: N IG A (7.10)
a a aα aα
and Ai has zero mean and unit variance. The factor M represents the systematic com-
mon market factor and Xi represents firm-specific factors. Equation (7.7) defines a
correlation structure between the random variables Ai . Then, the correlation between
the asset returns of two issuers is given by a2 , in the case of a homogeneous portfolio.
Conditional on M the asset returns of different issuers are independent.
Let us assume that default at time t occurs when the asset return of obligor i
falls below the threshold C(t), i.e., Ai ≤ C(t). Using this copula model, the variable
Ai is then mapped to default time τi of the i-th issuer with a percentile-to-percentile
transformation as described for example by [17] or [20]:
p(t) = P[τi ≤ t] = P[Ai ≤ C(t)] = N IG A (C(t)). (7.11)
p(t) = P[τi ≤ t] is the real-world distribution of default times estimated with a
migration matrix following [20]. According to Eq. (7.11), we conclude that C(t) =
N IG −1
A (p(t)) and thus
P[τi ≤ t] = P[Ai ≤ N IG −1 −1
A (p(t))] = P[p (N IG A (Ai )) ≤ t].
Now, we can simulate Ai according to Eq. (7.7) and determine the default times via
τi = p−1 (N IG(Ai )).
7.3. FRAMEWORK FOR TOTAL RETURN CALCULATION
Based on the simulations according to the previous section, we price the following
financial instruments: Government and corporate coupon bonds, funded CDS and
funded CDS indices. The pricing for all instruments is done under the following con-
ditions. We price the instruments at every simulated time step tk , k ∈ {0, . . . , p}, with
t0 < t1 < · · · < tp = T sim , where T sim denotes the end date of the simulation.
We assume that the cash flows occurring during the lifetime of the instrument are
reinvested in the respective instrument. For simplicity reasons, we assume a constant
recovery rate REC of 40% for all credit instruments in the case of a default rather than
using a stochastic recovery model. The constant recovery rate of 40% is in accordance
with the recovery rates for the iTraxx Europe (see www.indexco.com). The cash flows
at default time τ are invested in a risk-free cash account and they are compounded
at every simulated time step with the default risk-free government rate. We always
assume an initial investment of one unit.
The pricing and total return calculation of the bonds and the equity index is
straightforward. The pricing of the funded CDS and the funded CDS index, however,
is not trivial and is therefore derived in the following.
A CDS can be issued in a funded version. Then, the investor (protection seller)
buys a floating rate note (FRN), which pays a coupon of the three-month LIBOR plus
the fixed CDS spread on a quarterly basis. If no credit event occurs, the coupon is paid
until maturity. In this case, the investor receives the notional amount of the FRN. If,
however, a credit event of the reference entity takes place, the investor receives the
recovery value and the contract terminates. The functionality of a funded CDS index
is similar to funded CDS. It can be considered as a portfolio of funded CDS. If a credit
event of a reference entity takes place, the investor receives the recovery value, but
the notional amount of the FRN is reduced by the weight of the reference entity. If we
assume, for example, the first default in the reference portfolio containing 125 equally
weighted names, like the broadest and most actively traded investment-grade indices
CDX.NA.IG and the iTraxx Europe for North America and Europe, respectively, the
notional amout is reduced by 1/125 from 100% to 99.2%. The future coupon payments
are based on the new notional amount while the coupon rate remains unchanged.
We consider CDS and the CDS index from an investor’s perspective. Hence, we
view these instruments as an investment rather than as a means of hedging. Further-
more, we use the funded version of CDS and the CDS index for two reasons. First,
we can exclude counterparty risk from our considerations. Second, there are investors
who are for regulatory restrictions or due to internal investment policies not allowed
to enter into unfunded credit-derivative contracts.
Before explaining the total return components of these instruments, we briefly
describe the relationship between the relevant time steps. At every simulated time step,
tk ∈ {0, . . . , T sim }, we price the funded CDS/CDS index. Furthermore, we assume that
t1c < · · · < tnc = T denote the spread payment dates, where t1c denotes the next spread
payment date following the current pricing day, tk , and T denotes the maturity of the
CDS/CDS index. We denote the previous spread payment date or the settlement date,
if the first spread payment has not yet been made, by t0c . Spread payments are made in
arrear — at time tic for the payment period from ti−1c
to tic .
A funded CDS/CDS index has the following total return components: Present value
of the pure, default risk-free FRN at tk paying LIBOR (PVFRN ), coupon payments on the
notional amount at t0c , comprising LIBOR and the fixed spread S CDS , compounded to the
following simulated date tk (PVS ), recovery payments at default time τ, compounded to
the following simulated date tk (PVREC ), and the present value of the CDS/CDS index
(PVCDS ). PVCDS can be calculated for every pricing day tk . Its value can be either
positive, or negative, or zero depending on possible changes in the default intensity

λk at tk and on changes in the interest-rate curve. At inception of a funded CDS/CDS
index, the fixed spread is determined so that PVCDS is equal to zero, i.e., the fixed
spread is a fair price for the default intensity of the reference entity. During the term
of the contract, however, the default intensity of the reference entity can change, while
the fixed spread does not, resulting in a change in the value of PVCDS .
To determine the present value of the funded CDS/CDS index at tk , we need
to know the expected loss at tk up to every spread payment day, tic , i ∈ {1, . . . , n},
the premium leg and the protection leg. With the constant default intensity model, we
calculate the expected loss at tk up to tic according to EL(tk , tic , λk ) = 1−exp(−λk (tic −
tk )). This model assumes a constant default intensity, λk , for a given time tk . (This
implies that the partial recovery of market value in the extended model of Schmid and
Zagst is stochastic over time.) The premium leg is the present value of all expected
spread payments. It is calculated according to

n
Prem Leg(tk , T, S CDS , λk ) =
tic S CDS (1 − EL(tk , tic , λk ))P(tk , tic ),
i=1
where
tic = tic −ti−1
c
, S CDS is the fixed annual spread of the CDS/CDS index, P(tk , tic )
is the discount factor and 1 − EL(tk , tic , λk ) denotes the probability of no default up
to time tic .
The protection leg is the present value of all expected protection payments made
by the protection seller. As we assume a constant recovery rate REC, we can calculate
the protection leg by
T
Prot Leg(tk , T, λk ) = (1 − REC) P(tk , l) dEL(tk , l, λk )
tk

n
≈ (1 − REC) (EL(tk , tic , λk ) − EL(tk , ti−1
c
, λk ))P(tk , tic ).
i=1
At issuance of the funded CDS, the fixed annual spread S CDS is determined so that the
value of the premium leg equals the value of the protection leg:

(1 − REC) ni=1 (EL(tk , tic , λk ) − EL(tk , ti−1
c
, λk ))P(tk , tic )
S CDS = n . (7.12)
i=1
ti (1 − EL(tk , ti , λk ))P(tk , ti )
c c c
The equality of premium leg and protection leg as shown in Eq. (7.12) must also hold
for every day, when S CDS is substituted by the quoted par yield spread. For the sake
of simplicity, we use the simulated zero spread as the quoted par yield spread. The
absolute difference between the spreads, however, is very low. We analyzed historical
credit spreads from 31 December, 1991 to 29 September, 2006. The average difference
in this period was at most 1.5 bps for rating classes AA, A2 and BBB and maturities of
up to five years. The worst case on a single day was 4.9 bps. After this substitution, we
can solve the equation for λk and determine the constant (implied) default intensity at tk .
Let N(tk , τ) denote the notional amount of a funded CDS/CDS index at time step
tk . Then, the present value of the CDS/CDS index is given by
PVCDS (tk , T, S CDS , λk )
= (Prem Leg(tk , T, S CDS , λk ) − Prot Leg(tk , T, λk ))N(tk , τ). (7.13)
The calculation of the present values of the other total return components is straight-
forward. Then, we determine the total return of the investment, RCDS , for every tk > 0
by
PVCDS (tk , T, S CDS , λk ) + PVFRN (tk ) + PVREC (tk ) + PVS (tk )
RCDS (tk−1 , tk ) = − 1.
PVCDS (tk−1 , T, S CDS , λk−1 ) + PVFRN (tk−1 ) + PVREC (tk−1 )
7.4. OPTIMIZATION FRAMEWORK
For all optimization criteria, we make the following assumptions. There are neither
transaction costs nor taxes; all securities can be divided arbitrarily; the portfolios
remain unchanged over time; there are n given assets to invest in with returns Ri ,
i = 1, . . . , n; the expected return of asset i is given by µi := EP [Ri ] and µ :=

(µ1 , . . . , µn )T ; xi is the portfolio weight of asset i with ni=1 xi = 1, and the portfolio
is denoted by x := (x1 , . . . , xn )T .
7.4.1. Mean-Variance Optimization

The mean-variance optimization can be viewed as traditional portfolio optimization
and is based on the model of [7]. The basic assumption is that investors select their
portfolios taking into account only the first two moments of the asset returns — mean
and variance — and the correlation between the assets.
Let the covariance matrix be denoted by C = (cij )i,j=1,...,n , where cij =
Cov[Ri , Rj ], and let the variance be denoted by σi2 := cii > 0. Then, the mean-
variance optimization is given by the following optimization problem
min xT Cx (7.14)
x
s.t. µT x ≥ µ̄, 1T x = 1, x ≥ 0,
where 1 = (1, . . . , 1)T . If we solve the optimization problem in Eq. (7.14) for every
possible µ̄, we obtain the set of all efficient portfolios.
Obviously, the optimization problem in Eq. (7.14) only takes into account mean
and variance of a portfolio. This is appropriate, for example, if returns are normally
distributed. However, the returns of credit instruments are not normally distributed,
as seen earlier. Therefore, this criterion is only of limited use for the optimization of
portfolios including credit instruments.
7.4.2. CVaR Optimization

The conditional value at risk (CVaR) represents the expected value of all losses that
exceed a certain value at risk (VaR). Formally, we can define the CVaR as follows.
Let 1 − α be the confidence level for the VaR with α ∈ (0, 1). Then, the CVaR of a
portfolio’s return R(x) is given by
CVaR(x, α) = −EP [R(x) | R(x) ≤ CR (α)]

= −EP [R(x) | R(x) ≤ −VaR(x, α)], (7.15)
where CR (α) denotes the α-quantile of the portfolio’s return distribution R(x). From
the formulas above, it becomes evident that the CVaR provides information on the
negative tail of a return distribution since it is not only focussed on the α-quantile but
also takes into account the shape of its tail. This is of great importance if instruments
may default and so produce fat tails. The corresponding CVaR optimization is given by
min CVaR(x, α) (7.16)

x
s.t. µT x ≥ µ̄, 1T x = 1, x ≥ 0.
7.5. MODEL CALIBRATION AND SIMULATION RESULTS
We fit our model to market data as of 30 September, 2006 (simulation start date). To
calibrate the simulation model, we use parameters estimated by [21] and [22]. The
parameters for the short rate and the GDP growth rates are given by ar = 0.37867,
âr = 0.24782, br = 0.13315, σr = 0.01496, aω = 1.18532, âω = 0.26847, θω =
0.01583, σω = 0.00601. The credit spread parameters are displayed in Table 7.2.
We adjust the estimated parameters âs , âu , and bsu to better meet historical data in
terms of average spreads and spread ranges. For the inflation process and the process
for the equity-index returns, we use the following parameters (see [5] and [22]): ai =
0.64073, âi = 0.50319, θi = 1.04790, σi = 0.01447. αE = −3.07791, bER =
3.94000, bEi = 9.32436, bEω = 5.10643, σE = 0.16000. For the equity index, we
adjust the level of the returns and the standard deviation to better reflect the updated
historical data.
We want the U.S. CDS index to represent the current composition of the
CDX.NA.IG in terms of proportion of different rating classes. However, we assume the
U.S. CDS index (short CDX) only to be composed of the rating classes AA, A, and
BBB with the weights 12.28%, 39.47%, and 48.25%. We added the AAA rating class
Table 7.2 Parameter Estimation for Processes s

and u for Rating Classes AA, A2, BBB1.
AA A2 BBB1
as 2.96099 2.80727 2.41739

âs 2.96099 2.80727 2.41739
θs 0.00275 0.00251 0.00238
σs 0.00389 0.00309 0.00287
bsω 0.07373 0.07634 0.09369
au 0.11269 0.11057 0.11048
âu 0.02180 0.03210 0.04075
θu 0.12173 0.18566 0.18980
σu 0.00459 0.00476 0.00489
bsu 0.98404 0.92214 1.26089
to rating class AA and BB to BBB, as there are only parameters for the rating classes
AA, A, and BBB available. Furthermore, we normalized the weights to sum up to one.
For the simulation of correlated default times, we use the average one-year migra-
tion matrix for the United States, from 1981 to 2005, provided by [23]. The parameters
for the one-factor copula as of simulation start date are estimated in accordance with the
model introduced by [6]. We use the following parameters a = 0.37029, α = 0.70138,
β = 0. So, the correlation a of a single reference entity to the common market factor
is equivalent to a correlation between two reference entities of a2 = 0.13711.
Having simulated 5,000 scenarios on a quarterly basis with government interest
rates, credit spreads and correlated default times, we can now price various financial
instruments. All bonds, CDS and the CDX, are assumed to have an initial term of
approximately five years.
Table 7.3 reports the return characteristics for investment horizons one year and
three years. Here, we make some general observations. We see higher expected returns
and higher standard deviations or levels of CVaR with decreasing credit quality of
the bonds. Besides, we observe that — as soon as defaults have occurred — the
distributions of credit instruments become non-normal. This can be shown by some
statistics: The skewness of the credit instruments is negative, the excess kurtosis is
significantly higher than 0 and minimum values always indicate defaults. The non-
normality can also be verified easily by Jarque–Bera tests. For the one year investment
horizon, the AA and A-rated CDS and the CDX have considerably less volatility and
a lower CVaR than government and corporate bonds. At the same time, CDS and the
CDX have a similar expected return to government bonds. Though, comparing the one-
year and the three-year investment horizon, we make an interesting observation. For the
three-year horizon, the CDS have a similar or higher risk than the corporate bonds and a
May 12, 2010
Asset Allocation with Credit Instruments
17:47
Table 7.3 Key Statistics of Total Returns of Financial Instruments.
Govt. Equity Bond Bond Bond CDS CDS CDS CDS

bond index AA A BBB index AA A BBB
WSPC/SPI-B913
1 Year
Mean 5.55% 10.43% 6.03% 6.19% 6.37% 5.49% 5.75% 5.92% 6.10%
Median 5.50% 8.25% 6.01% 6.18% 6.51% 5.52% 5.77% 5.95% 6.27%
σ 3.16% 19.30% 3.35% 3.57% 4.73% 0.74% 1.13% 1.70% 3.46%
CVaR(1%) 2.55% 32.14% 3.24% 5.34% 17.71% −2.60% −2.64% −0.39% 13.24%
Min −4.35% −43.08% −59.17% −58.22% −58.17% −13.27% −57.44% −57.72% −57.28%
Max 17.01% 88.10% 17.18% 18.12% 19.63% 7.59% 8.46% 8.54% 10.00%
Skewness 0.0900 0.5568 −1.3820 −3.3200 −6.7629 −5.1385 −34.6157 −30.6476 −16.6226
Excess kurtosis 0.0276 0.4571 28.2614 59.8199 90.1579 109.6775 1927.6047 1135.5933 298.5225
3 Years
Mean 16.57% 33.44% 18.04% 18.55% 19.08% 16.43% 17.20% 17.73% 18.41%
Median 16.58% 24.29% 18.16% 18.86% 19.99% 16.46% 17.25% 17.93% 19.10%
b913-ch07
σ 2.67% 52.74% 3.86% 5.34% 8.77% 3.33% 4.18% 5.43% 8.06%
CVaR(1%) −9.41% 54.45% −1.53% 14.83% 53.12% −5.77% 0.65% 15.09% 51.90%
Min 7.32% −67.75% −55.18% −55.41% −55.20% −30.08% −54.21% −54.58% −54.77%
Max 25.13% 439.46% 27.26% 28.12% 30.60% 27.25% 29.06% 30.19% 32.05%
FA
Skewness −0.0188 1.3790 −9.2575 −9.8637 −7.1960 −0.9070 −7.3939 −8.4513 −7.1697
Excess kurtosis −0.0459 3.8584 172.4228 131.3360 56.2670 10.8976 123.0516 107.1262 59.9592
159
lower return. This phenomenon can be easily explained by the nature of the instruments.
Fixed-income instruments are exposed to market risk which is the higher, the longer
the time to maturity. CDS and the CDX are very similar to an FRN and only have a
very small market risk. They pay the short-term interest rate, which is lower than the
medium-term interest rates if the curve is normal. In addition, the outcome of interest
rates is more volatile over a longer investment horizon. In Table 7.4, we show the linear
correlations between the returns of the financial instruments for the investment horizons
one year and three years. We make the following main observations: Government-bond
and corporate-bond returns have a high positive correlation. This is reasonable as the
main driver of the bond return is the government rate, which is the same for all bonds.
Differences in bond returns come from different credit spreads and different default
times. Bond and equity-index returns are negatively correlated, which is also known
from historical time series. There is a small positive or negative correlation between
returns of corporate bonds and funded CDS/CDX. This may seem counterintuitive at
first sight. A closer look at the nature of these instruments proves otherwise. We need
to differentiate between two opposing effects, which can be attributed to single return
components of the funded CDS/CDX. On the one hand, the present value of the CDS
PVCDS (see Eq. (7.13)) strongly behaves like the price of the corporate bond. Zero rates
being equal, PVCDS and the price of the corporate bond decrease if spreads increase
resulting in a high positive correlation. On the other hand, bonds are fixed income
instruments with prices that strongly depend on the level and the structure of zero
rates. If zero rates are falling, the bond returns increase as bond prices increase. For
the FRN linked to the CDS/CDX, it is the other way round. Since its return strongly
depends on the floating LIBOR, the return of the FRN tends to decrease with falling
interest rates resulting in a high negative correlation between bond returns and returns
of funded CDS/CDX. All in all, the two opposing effects cancel each other out to a
certain degree resulting in a small positive or negative correlation between corporate
bonds and funded CDS/CDX. The returns of the equity index and CDS or the CDX
are positively correlated. This is reasonable since both equity-index returns and the
three-month government rate are to a large proportion driven by the short rate, which
was empirically confirmed by [5].
To conclude, we identify appealing risk–return profiles and low correlations
between bonds, the equity index and CDS/CDX. Therefore, investors should bene-
fit from holding a portfolio consisting of traditional financial instruments and credit
instruments.
After having analyzed the return characteristics, we can turn to portfolio optimiza-
tion. For this purpose, we consider a one-year and a three-year investment horizon and
the following three investment universes: Initial investment universe consisting of
government bonds and an equity index; extension by corporate bonds; extension by
CDS and the CDX.
May 12, 2010
Asset Allocation with Credit Instruments
17:47
Table 7.4 Correlation of Total Returns of Financial Instruments.
Govt. Equity Bond Bond Bond CDS CDS CDS CDS
bond index AA A BBB index AA A BBB
WSPC/SPI-B913
1 Year
Govt. bond 1.0000 −0.1184 0.9508 0.8824 0.6828 −0.2338 −0.1569 −0.1013 −0.0510
Equity index −0.1184 1.0000 −0.1182 −0.1110 −0.0835 0.1124 0.0751 0.0639 0.0104
Bond AA 0.9508 −0.1182 1.0000 0.8391 0.6511 −0.2227 −0.0781 −0.0986 −0.0465
Bond A 0.8824 −0.1110 0.8391 1.0000 0.6002 −0.1934 −0.1385 −0.0417 −0.0482
Bond BBB 0.6828 −0.0835 0.6511 0.6002 1.0000 −0.0104 −0.1061 0.0265 0.0560
CDS index −0.2338 0.1124 −0.2227 −0.1934 −0.0104 1.0000 0.2652 0.2802 0.1830
CDS AA −0.1569 0.0751 −0.0781 −0.1385 −0.1061 0.2652 1.0000 0.1107 0.0632
CDS A −0.1013 0.0639 −0.0986 −0.0417 0.0265 0.2802 0.1107 1.0000 0.0395
CDS BBB −0.0510 0.0104 −0.0465 −0.0482 0.0560 0.1830 0.0632 0.0395 1.0000
3 Years
Govt. bond 1.0000 −0.1629 0.7001 0.5086 0.3271 −0.4689 −0.3812 −0.2919 −0.1814
Equity index −0.1629 1.0000 −0.1068 −0.1014 −0.0593 0.2651 0.2201 0.1764 0.1045
b913-ch07
Bond AA 0.7001 −0.1068 1.0000 0.3543 0.2511 −0.2249 −0.2387 −0.1934 −0.0579
Bond A 0.5086 −0.1014 0.3543 1.0000 0.2027 −0.1772 −0.1930 −0.0712 −0.0726
Bond BBB 0.3271 −0.0593 0.2511 0.2027 1.0000 −0.0816 −0.1103 −0.0901 −0.0209
CDS index −0.4689 0.2651 −0.2249 −0.1772 −0.0816 1.0000 0.6809 0.5481 0.4063
CDS AA −0.3812 0.2201 −0.2387 −0.1930 −0.1103 0.6809 1.0000 0.4113 0.2732
FA
CDS A −0.2919 0.1764 −0.1934 −0.0712 −0.0901 0.5481 0.4113 1.0000 0.2070
CDS BBB −0.1814 0.1045 −0.0579 −0.0726 −0.0209 0.4063 0.2732 0.2070 1.0000
161
7.5.1. Mean-Variance Approach

With a mean-variance optimization according to the optimization problem in Eq. (7.14)
for the relevant investment universes as described above, we obtain efficient frontiers
and the corresponding asset allocations. The results are displayed in Fig. 7.1 for the
one-year investment horizon and in Fig. 7.2 for an investment horizon of three years.
The upper part of the figures show the efficient frontiers, the lower parts of the figures
contain the optimal asset allocations along the efficient frontiers. For the sake of read-
ability, the results of the asset’s weights in the portfolio are partly aggregated, i.e., the
element “Bonds AA/A/BBB” represents the corporate bonds with a rating of AA, A, or
BBB and is the sum of all corporate bond weights in a certain optimal asset allocation,
“CDS AA/A/BBB” represents all single-name CDS rated AA, A, or BBB in a certain
allocation.
The figures exhibit some similar structures. At first, we examine the efficient
frontiers. Allowing for corporate bonds in the portfolio optimization leads to an upward
shift of the efficient frontiers compared to the initial investment universe. For the same
level of risk, a higher expected return can be generated. Allowing additionally for
CDS and the CDX leads to a shift of the efficient frontier to the left, i.e., an investor
can reduce the portfolio risk. The proportion of the potential risk reduction or return
enhancement depends on the investment horizon. In Table 7.5, we show the potential
improvement of the investor’s portfolio risk and/or return position exemplarily for
a one-year horizon using the minimum-variance portfolio of the initial investment
universe as a reference point.
Table 7.5 shows that the minimum variance portfolio based on the initial invest-
ment universe has an expected return of 5.76% and a standard deviation of 3.04%.
This portfolio is compared to equivalent portfolios on the most extended investment
universe, i.e., allowing not only for government bonds and an equity index, but also for
all relevant credit instruments. The appropriate portfolios can be identified by either
holding the expected return constant and looking for the standard deviation of the
equivalent portfolio on the efficient frontier of the most extended investment universe,
or holding the standard deviation constant and looking for the expected return on the
efficient frontier. In the first case, the portfolio’s standard deviation is only 0.70%, in
the second case the expected return is 6.72%. The results from the Table 7.5 allow the
conclusion that a mean-variance investor can reduce his portfolio’s risk and/or enhance
the return by adding credit instruments to the portfolio of government bonds and an
equity index. Similar improvements of the risk and/or return position can be observed
for the three-year investment horizon.
Now, we focus on the mean-variance optimal asset allocations, i.e., the lower
parts of Figs. 7.1 and 7.2. In the initial investment universe, optimal allocations only
consist of government bonds and an equity index. In the largest investment universe,
11
10
Expected return (%)
4
0 5 10 15 20 25
Standard deviation (%)
Equity Index and Government Bonds

Equity Index, Government Bonds, Corporate Bonds
Equity Index, Government Bonds, Corporate Bondsand CDS/CDX
100
90
Portfolio weights (%)
80
70
60
50
40
30
20
10
0
3.30
4.17
0.61
0.76
1.14
1.75
2.48
5.08
6.04
7.03
8.05
9.09
10.16
11.26
12.38
13.52
14.67
15.83
16.99
18.17

Equity Index Government Bonds CDX
CDS AA/A/BBB Bonds AA/A/BBB
Figure 7.1 Results of mean-variance optimization, one-year investment horizon.
government bonds are substituted to a large extent with corporate bonds, CDS, and
the CDX. As already seen from Table 7.3, AA and A-rated CDS and the CDX have
a similar expected return compared to government bonds but a considerably lower
standard deviation for a one-year horizon. Therefore, particularly for lower levels of
standard deviation, optimal portfolios contain a considerable proportion of CDS and
the CDX. For levels of standard deviation higher than 7.64% (one-year horizon) and
10.38% (three-year horizon), an optimal portfolio only consists of corporate bonds and
an equity index. For lower levels of standard deviation, corporate bonds are partially
replaced by CDS and the CDX. There is only a rather small proportion of government
bonds for a low level of risk, due to the risk–return profile of government bonds
and CDS.
35
33
31
Expected return (%)
29
27
25
23
21
19
17
15
0 10 20 30 40 50 60

Equity Index, Government Bonds, Corporate Bonds and CDS/CDX
100
90
80
70
60
50
40
30
20
10
0
8.21
10.81
1.50
1.84
2.49
3.86
5.86
13.55
16.38
19.26
22.17
25.13
28.13
31.17
34.23
37.31
40.40
43.50
46.62
49.74

Figure 7.2 Results of mean-variance optimization, three-year investment horizon.
7.5.2. Conditional Value at Risk

In the CVaR optimization, we assume α to be 1%, i.e., we consider the mean of the
worst 1% of the portfolio return as risk measure. The resulting efficient frontiers and
the optimal asset allocations are displayed in Fig. 7.3 for the one-year investment
horizon and in Fig. 7.4 for the three-year investment horizon. When comparing the
results of the CVaR optimization with those of the mean-variance optimization, the
first impression is very similar. In the following, we describe the main results of
Table 7.5 Comparison of Selected Mean-Variance Optimal Portfolios

Based on Two Different Investment Universes, One-Year Investment
Horizon.
Investment universe Portfolio selection criterion µ (%) σ (%)
Initial Minimum variance portfolio 5.76 3.04

Most extended Equal portfolio return 5.76 0.70
Most extended Equal portfolio standard deviation 6.72 3.04
the CVaR optimization at first. Then, we describe and explain some differences of
mean-variance and CVaR optimization. We begin with the efficient frontiers. Adding
credit instruments to a portfolio only consisting of the initial investment universe leads
to an upward shift and a shift to the left of the efficient frontier. This indicates that
there is an enormous potential for return enhancement or risk reduction. The potential
depends on the investment horizon. It is exemplarily illustrated for the minimum-CVaR
portfolio as a reference point, in Table 7.6.
Table 7.6 reveals that for a one-year investment horizon there is a high potential to
either reduce the risk for a given level of return (from a CVaR of 2.10% to a CVaR of
only −3.12%), or to enhance the portfolio return for a given level of risk (from 5.79%
to 6.78%). Also for a three-year investment horizon there is a high potential to reduce
risk and/or enhance return.
Next, we analyze the optimal asset allocations for an investor using the CVaR-
criterion. In an optimal portfolio, government bonds are partially substituted with
corporate bonds, CDS and the CDX compared to the initial investment universe. As
explained earlier, AA- and A-rated CDS and the CDX have a similar expected return
to government bonds, but a lower CVaR for a one-year horizon. Particularly for low
levels of CVaR, corporate bonds are partially substituted with CDS and the CDX.
For levels of CVaR higher than 18.29% (one-year horizon) and 14.47% (three-year
horizon), an optimal portfolio only consists of corporate bonds and an equity index.
If, however, lower levels of CVaR are of interest, optimal allocations are composed of
a considerable proportion of credit derivatives.
Having a closer look at the resulting optimal allocations of mean-variance and
CVaR optimizations, we can identify some differences. For a one-year investment
horizon, optimal allocations contain CDS even for high levels of expected returns.
While mean-variance optimal portfolios are composed of CDS up to an expected
portfolio return of 7.91%, CVaR optimal portfolios hold CDS up to a return level of
8.94%. In contrast, CVaR optimal portfolios contain significantly less BBB-rated, but
significantly more AA-rated corporate bonds. For a three-year investment horizon,
CVaR optimal portfolios hold CDS up to an expected portfolio return of 25.30%,
while mean-variance optimal portfolios only consist of CDS up to returns of 21.53%.
11
10
Expected return (%)
4
−10 −5 0 5 10 15 20 25 30 35
CVaR (%)

100
90
80
70
60
50
40
30
20
10
0
9.62
11.57
13.55
15.58
17.62
19.77
22.03
24.32
26.64
28.97
31.36
−3.30
−2.78
−1.60
−0.20
1.27
2.77
4.27
5.92
7.74
CVaR (%)
Figure 7.3 Results of CVaR optimization, one-year investment horizon.
Furthermore, the former are composed of a significant larger proportion of government

bonds than the latter. Again, we observe a considerably lower proportion of BBB-
rated corporate bonds for the CVaR optimal portfolios. BBB-rated bonds provide a
rather high expected return. Though, the standard deviation is not able to adequately
capture the tail events. From these observations, we can conclude that the mean-
variance optimization underestimates the benefits of credit derivatives, particularly
for longer investment horizons, by only considering the first two moments of the
return distribution, and not its tail. Moreover, it overestimates the benefits of BBB-
rated corporate bonds by only looking at the expected return and volatility but mainly
ignoring the tail events. Our analysis show that an investor, optimizing his portfolio
35
33
31
29
Expected return (%)
27
25
23
21
19
17
15
−20 −10 0 10 20 30 40 50 60
CVaR (%)

100
90
80
70
60
50
40
30
20
10
0
−12.00
−11.02
−9.34
−7.18
−4.67
−1.94
0.84
3.78
6.98
10.51
14.17
18.02
21.92
25.93
30.07
34.31
47.12
38.55
42.79
51.57
CVaR (%)
CDSAA/A/BBB Bonds AA/A/BBB
Figure 7.4 Results of CVaR optimization, three-year investment horizon.
with either the mean-variance or the CVaR criterion, can add performance to his
portfolio for a given level of risk, or he can reduce risk for a given target return level.
This can be realized due to a low correlation between the different instruments and
their attractive risk–return profile.
7.5.3. Comparison of Selected Optimal Portfolios

We close our analysis of the simulation results with a comparison of selected optimal
portfolios. We examine the optimal asset allocation for two representative investors
which we denote by risk–averse and risk–affine. Note that the term risk–affine does
Table 7.6 Comparison of Selected CVaR-Optimal Portfolios Based

on Two Different Investment Universes, One-Year Investment Horizon.
Investment universe Portfolio selection criterion µ (%) CVaR (%)
Initial Minimum-CVaR portfolio 5.79 2.10

Most extended Equal portfolio return 5.79 −3.12
Most extended Equal portfolio standard deviation 6.78 2.10
Table 7.7 Benchmark Portfolios for a Risk–Averse and a Risk–Affine

Investor.
Risk–averse investor (%) Risk–affine investor (%)
Govt. bond 70.00 30.00

Equity index 30.00 70.00
not mean that this investor is seeking risk. He is rather willing to bear more risk than
the risk–averse investor in compensation for a higher risk premium. Their respective
benchmark portfolio is defined on the initial investment universe and is exhibited in
Table 7.7.
The procedure for selecting the optimal portfolios to compare with the benchmark
portfolios is the following. At first, we determine the risk and return characteristics
of the benchmark portfolios, denoted as “riskB ” and “returnB ”, where “riskB ” refers
to the relevant risk measure: If optimal portfolios are selected using mean-variance
approach (MV), the relevant risk measure is standard deviation, in the case of CVaR
optimization it is the CVaR. We use these risk values as reference points to find the
optimal portfolios with identical risk values on the efficient frontiers of the most
extended investment universe based on the results of mean-variance and the CVaR-
optimization presented in the previous sections (see Figs. 7.1–7.4). The results are
shown in Tables 7.8 and 7.9 for the one-year and the three-year investment horizon,
respectively.
In the upper parts of the Tables 7.8 and 7.9 the risk–return profiles of the benchmark
portfolios and the optimal portfolios (denoted as “risk∗ ”, “return∗ ”) can be found. In
addition, the corresponding optimal asset allocations are displayed in the lower part
of these tables.
Tables 7.8 and 7.9 reveal some interesting characteristics of mean-variance opti-
mal and CVaR optimal portfolios for the risk–averse and risk–affine investor defined
in Table 7.7. At first, we focus on some similarities. Mean-variance and CVaR opti-
mization lead to similar expected portfolio returns. Extending the investment universe
by credit instruments an investor always can enhance the portfolio return. A risk–
averse investor with a one-year investment horizon can increase his portfolio return
Table 7.8 Comparison of Benchmark Portfolios and Opti-

mal Portfolios for Risk–Averse and Risk–Affine Investor,
One-Year Investment Horizon.
Risk–averse investor Risk–affine investor
MV (%) CVaR (%) MV (%) CVaR (%)
RiskB 5.95 6.52 13.43 20.52

ReturnB 7.01 7.01 8.97 8.97
Risk∗ 5.95 6.52 13.43 20.52
Return∗ 7.50 7.47 9.21 9.20
Govt. bond 0.00 0.00 0.00 0.00
Equity index 29.50 31.01 69.82 69.93
Bond AA 0.00 24.05 0.00 0.00
Bond A 20.38 27.10 0.00 7.16
Bond BBB 37.94 6.46 30.18 22.90
CDS index 0.00 0.00 0.00 0.00
CDS 12.18 11.39 0.00 0.00
Table 7.9 Comparison of Benchmark Portfolios and Opti-

mal Portfolios for Risk–Averse and Risk–Affine Investor,
Three-Year Investment Horizon.
Risk-averse investor Risk-affine investor
MV (%) CVaR (%) MV (%) CVaR (%)
RiskB 15.63 4.52 36.80 32.76

ReturnB 21.63 21.63 28.38 28.38
Risk∗ 15.63 4.52 36.80 32.76
Return∗ 23.13 22.88 29.12 29.18
Govt. bond 0.00 0.00 0.00 0.00
Equity index 29.04 30.14 69.89 70.89
Bond AA 0.00 24.80 0.00 0.00
Bond A 23.32 21.86 0.00 15.86
Bond BBB 47.64 11.20 30.11 13.25
CDS Index 0.00 0.00 0.00 0.00
CDS 0.00 12.00 0.00 0.00
from 7.01% to 7.50% applying the mean-variance optimization and to 7.47% applying
the CVaR optimization. A risk–affine investor with a three-year investment horizon
increases his portfolio return from 28.38% to 29.12% (MV) or to 29.18% (CVaR).
The proportion of the equity index in an optimal portfolio is always rather close to the
proportion of the benchmark portfolio, i.e., it is approximately 30% for the risk–averse
investor and 70% for the risk–affine investor. However, the equity proportion is always
slightly higher for investors using the CVaR criterion. The two investors should never
allocate funds in government bonds to build an optimal portfolio. The proportion of the
government bonds in the benchmark portfolios is rather reallocated to the credit instru-
ments in the optimized portfolios, particularly to corporate bonds and CDS. For the
considered levels of risk, the CDS Index does not play a role. For the one-year hori-
zon both optimization approaches lead to a proportion of approximately 11–12% of
CDS for the risk–averse investor. Independent of optimization criterion or investment
horizon, the risk–affine investor should not invest in CDS. Having a closer look at the
proportions of the credit instruments, we can figure out some interesting differences.
A risk–averse investor applying the CVaR criterion and having three-year investment
horizon should still allocate approximately 12% to CDS, while this investor using
the mean-variance criterion should not hold CDS in his portfolio. This indicates that
mean-variance optimization underestimates the benefit of credit derivatives for longer
investment horizons. For both investment horizons, mean-variance optimal portfo-
lios contain a considerably higher proportion of BBB-rated corporate bonds than the
CVaR-optimal portfolios. This means that mean-variance optimization overestimates
the benefits of BBB-rated corporate bonds by only taking the expected return and
volatility into account but mainly ignoring the tail events. These effects were already
explained in the previous section.
To sum up, comparing the resulting optimal asset allocations for a representative
risk–averse and risk–affine investor, we see that, independent of investment horizon and
optimization criterion, an investor always benefits from substituting government bonds
by corporate bonds, CDS, and the CDX. The resulting optimal allocations, however,
strongly depend on the investor type, the optimization criterion and the investment
horizon.
7.6. SUMMARY AND CONCLUSION
Constructing portfolios with credit instruments requires an appropriate asset allo-

cation framework in order to account for the distinct return characteristics of these
instruments, such as non-normality of the return distribution due to potential defaults.
We have presented a consistent, scenario-based asset allocation framework, which is
able to determine optimal portfolios consisting of traditional instruments and credit
instruments. The entire framework is composed of a simulation, a total return cal-
culation, and an optimization framework. We have suggested a model to simulate
consistent capital-market scenarios offering analytical formulas for the whole term
structure of interest rates and credit spreads. Furthermore, we have introduced a
model to simulate correlated default times with an NIG one-factor copula, which
is an extension of the Gaussian one-factor copula. The NIG version is appealing since
it allows to generate more realistic properties of default times such as a higher prob-
ability of joint defaults of different issuers. After the introduction of general con-
ditions for the total return calculations, we have explained how to price CDS. For
portfolio optimization we have applied two criteria — the mean-variance and the
CVaR optimization. The former can be viewed as traditional portfolio optimization.
Its main disadvantage is that it only takes the first two moments of a return dis-
tribution into account, which is obviously not appropriate when also allowing for
credit instruments. The latter is able to overcome this drawback since it considers
the left tail of a distribution. So, it particularly takes defaults into account. Finally,
we have presented the model parameters and we have applied our asset allocation
framework to the U.S. market for a one-year and a three-year investment horizon.
We have found that credit instruments have an appealing risk–return profile and a
correlation structure providing a considerable potential for diversification. Moreover,
we have found that mean-variance optimization overestimates the benefits of low-
rated bonds by only focussing on mean and variance, and mainly ignoring the tail
events.
Realistic modeling of return characteristics is very important when instruments
with specific return characteristics are included in an asset allocation. Otherwise, opti-
mization results are not more than an approximation. Our model provides realistic
return distributions. Furthermore, it can be fitted to market data and it can be easily
extended by other credit instruments. Therefore, it is appropriate for an asset allocation
with credit instruments.
APPENDIX
The zero rates R(t, T ) and Rd (t, T ) at time t to maturity T of non-defaultable and
defaultable bonds as well as the credit spreads S(t, T ) are given by
1
R(t, T ) = − [A(t, T ) − B(t, T )rt − D(t, T )ωt ],
T −t
1
Rd (t, T ) = − [Ad (t, T ) − B(t, T )rt − Dd (t, T )ωt − Ed (t, T )ut − F d (t, T )st ],
T −t
1
S(t, T ) = − [Ad (t, T ) − A(t, T ) − (Dd (t, T ) − D(t, T ))ωt
T −t
− Ed (t, T )ut − F d (t, T )st ],
with
T

1 2
A(t, T ) = (σ B(l, T ) + σω D(l, T ) ) − θr (l)B(l, T ) − θω D(l, T ) dl,
2 2 2
t 2 r
T
1
Ad (t, T ) = [σr2 B(l, T )2 + σω2 Dd (l, T )2 + σu2 Ed (l, T )2 + σs2 F d (l, T )2 ]dl
2 t
T
− [θr (l)B(l, T ) + θω Dd (l, T ) + θu Ed (l, T ) + θs F d (l, T )]dl,
t
1
B(t, T ) = (1 − e−âr (T −t) ),
âr

br 1 − e−âω (T −t) e−âω (T −t) − e−âr (T −t)
D(t, T ) = + ,
âr âω âω − âr

bsω 1 − e−âω (T −t) e−âω (T −t) − e−âs (T −t)
D (t, T ) = D(t, T ) −
d
+ ,
âs âω âω − âs

bsu 1 − e−âu (T −t) e−âu (T −t) − e−âs (T −t)
E (t, T ) =
d
+ ,
âs âu âu − âs
1
F d (t, T ) = (1 − e−âs (T −t) ).
âs
For an explicit derivation of the zero rates, we refer to [4].
References
[1] FitchRatings (2005). Global credit derivatives survey: Risk dispersion accelerates.
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summary.
[3] Bank for International Settlements (2009). BIS quarterly review June 2009: International
banking and financial market developments.
[4] Antes, S., M Ilg, B Schmid and R Zagst (2008). Empirical evaluation of hybrid defaultable
bond pricing models. Journal Applied Mathematical Finance, 15(3), 219–249.
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markets. International Journal of Finance, 19(1), 4252–4277.
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for sythetic CDO pricing. Journal of Derivatives, Spring.
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ii: Two-factor models. Journal of Derivatives.
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[13] Feldstein, M (1980). Inflation and the stock market. American Economic Review, 70,
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[17] Hull, J and A White (2004). Valuation of a CDO and an n-th to default CDS without a
Monte Carlo simulation. Journal of Derivatives.
[18] Kalemanova, A and R Werner (2006). A short note on the efficient implementation of the
Normal Inverse Gaussian distribution. Working Paper.
[19] Vasicek, O (1987). Probability of loss on loan portflio. Memo, KMV Corporation.
[20] Bluhm, C (2003). CDO modeling: Techniques, examples and applications. Working Paper.
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[23] Standard & Poor’s (2006) Annual 2005 global corporate default study and rating transi-
tions.

CROSS ASSET PORTFOLIO

DERIVATIVES
8
STEPHAN HÖCHT∗,‡ , MATTHIAS SCHERER∗,§
and PHILIP SEEGERER†,¶
∗
HVB-Stiftungsinstitut für Finanzmathematik, Technische Universität München,
Boltzmannstrasse 3, 85748 Garching bei München, Germany
†
Assenagon GmbH, Theresienhöhe 13 a, 80339 München, Germany
‡
hoecht@tum.de
§
scherer@tum.de
¶
philip.seegerer@assenagon.com
The dependence of extreme financial events among different asset classes is taken
under consideration on a portfolio level. For this, a new product group, called cross
asset portfolio derivatives, is introduced and explained in the light of related existing
products and pricing methods. A classification is presented and features of these prod-
ucts are described. Finally, two modeling and pricing frameworks using multivariate
stochastic processes and (hierarchical) copulas, respectively, are suggested.
8.1. INTRODUCTION TO CROSS ASSET PORTFOLIO

DERIVATIVES
This chapter focuses on the dependence of tail events, i.e., the risk of rare market events
occurring interdependently. A current trend in product development is to apply credit
175
176 Höcht et al.
derivative techniques on stylized insurance claims based on various assets. Hence, we

aim at extending the well established concepts for the pricing of credit derivatives,
such as credit default swaps (CDS), nth-to-default baskets, and collateralized debt
obligations (CDO), to other asset classes in the form of new investment products.
Asset classes that might serve as underlyings are equity, commodity, interest rates, and
foreign exchange. Thereby, we focus on the dependence of tail events among different
asset classes in these products. The following definitions were adopted from the world
of credit derivatives, see [1], page 8 ff, and generalized to trigger derivatives.
8.1.1. Definitions and Examples

A trigger event causes a payment stream in some derivative. The default of a company
(credit event) in the case of a CDS or the drop of a stock below a specified trigger
level (equity event) in the case of an equity default swap (EDS) are examples. Very
unlikely trigger events, such as a steep sudden drop of an equity index (equity tail
event) or the sudden default of an AAA-rated company (credit tail event), are referred
to as tail events. A trigger derivative is a bilateral derivative security, where the payoff
profile depends on the occurrence of a trigger event. The trigger event is defined
with respect to one (or several) reference underlying(s). After the trigger event has
occurred, a contingent payment is due by one of the contractual parties. In case of an
asset trigger derivative, the trigger event is defined with respect to a tradable reference
underlying.
Single name asset trigger derivatives (SNATD) stand for only one reference under-
lying in the contract and are represented by trigger swaps (TS ). These are agreements
between two contractual parties to exchange the risk of a reference asset hitting a pre-
defined trigger level. More precisely, one party receives periodic premium payments
as long as the trigger event has not taken place. In return, the other party receives a
contingent payment at the time of the trigger event. Trigger swaps might be interpreted
as EDS (or CDS) extended to other asset classes; the difference of the first to the lat-
ter being that the underlying does not default on some equity event (or credit event),
instead, the trigger event is defined on a tradable asset. In the context of options, TS
might also be seen as digital one-touch options or barrier options, see [2], page 561.
In contrast to CDS contracts, where the reimbursement rate (RIR), i.e., one minus
the recovery rate, is usually not known prior to the credit event, in a trigger swap the
reimbursement rate is fixed as part of the contractual specifications. A range from 50%
to 100% seems to be realistic.
Whereas SNATD relates to a single reference underlying, portfolio asset trigger
derivatives (PATD) have payment streams that are linked to a portfolio of underlyings.
At the next level, we distinguish between mono asset portfolio derivatives and cross
asset portfolio derivatives. Mono asset portfolio derivatives (MAPD) are derivatives
Cross Asset Portfolio Derivatives 177
with a payoff, which is contingent on trigger events referring to an underlying pool of

trigger swaps from the same asset class. Generalizing mono asset portfolio derivatives
to multiple asset classes leads to cross asset portfolio derivatives (CAPD).
Considering the specific payment schemes, we can distinguish between nth-to-
trigger baskets and collateralized trigger swap obligations (CTSO). The former are
portfolio derivatives with a contingent payment depending on the nth trigger event in
the underlying portfolio of trigger swaps, the latter are tranched securities which are
backed by a pool of TS. In case of a CTSO, the underlying portfolio is composed of
I trigger swaps, where I is typically in the range of 50–200. In contrast to synthetic
CDO, where the underlying CDS are linked to different credits, two trigger swaps in
a CTSO portfolio might refer to the same underlying asset, however, with different
trigger events/trigger levels. The portfolio’s notional, i.e., the sum of the TS’s individual
notionals, can be divided into different tranches. Similar to a TS providing exposure to
the trigger event risk of the reference asset, a tranche of a CTSO provides exposure to the
risk of a particular amount of loss on a portfolio of assets. An investor can decide how
much trigger event exposure she is willing to take from the portfolio. This is achieved
by choosing a specific tranche, i.e., by choosing a particular level of subordination.
In the case where only one underlying asset class is considered, these products were
already introduced to the market. Examples are collateralized commodity obligations
(CCO) and collateralized foreign exchange obligations (CFXO). In the case of a CFXO,
with foreign exchange rate TS serving as the underlying portfolio, several TS for each
foreign exchange rate (with a cascade of trigger levels) are included in the underlying
portfolio. The following example illustrates the general structure of a CTSO and the
involved tranche structure.
Example 1 (General structure of a CTSO). Consider a CTSO consisting of 100 TS

with a notional of one million US$ each. Instead of taking a linear exposure in all
TS simultaneously, which corresponds to selling all TS, an investor (insurance seller)
decides to invest in the (10%, 20%) tranche of the CTSO with notional size 10 million.
The tranche’s boundaries are called attachment and detachment points. The resulting
payoff schedule is as follows: the investor receives a regular periodic spread on the
remaining outstanding notional of the invested tranche. If one TS in the portfolio is
triggered, the portfolio’s notional is reduced to 99 million (assuming a reimbursement
rate of 100%) and the subordination of the investor’s tranche is reduced to (9%, 19%).
If the 11th trigger in the portfolio occurs, the investor’s tranche is hit for the first time.
The tranche’s remaining notional reduces to nine million and a contingent payment of
one million has to be paid to the protection buyer. Since spread is paid pro rata to the
remaining tranche, spread payments are reduced accordingly in the following. With
the 20th trigger occurring in the portfolio, the whole tranche notional is eliminated and
further spread payments are stopped. Since the first loss occurs with the 11th trigger
178 Höcht et al.
and the total loss is realized with the 20th, the result is an option-like payoff. This
option-type behavior can be used to introduce the leverage into the investment.
Due to the so-called waterfall structure of the tranched CTSO, the investor can
choose different subordination levels. This choice determines the real trigger event
exposure to the portfolio. A less senior tranche bears a higher trigger risk, but bearing
this risk is compensated with higher spread on the outstanding notional. In case of a
CDO, one often classifies the subordination in equity, mezzanine, and senior tranches.
These names intend to reflect the different risk exposures.
Example 2 (General structure of an nth-to-trigger basket). Consider a portfolio
of 10 TS, with a notional of one million US$ each, and an investor (insurance buyer)
who wants to protect herself against the first loss in the portfolio by means of a first-to-
trigger swap. For this, she pays periodic premium payments on a pre-specified sched-
ule. As soon as one of the TS is triggered, premium payments stop and she receives
a contingent payment in the amount of reimbursement rate times the notional. For
n > 1, nth-to-trigger derivatives are defined similarly, with the first trigger replaced
by the nth trigger.
Figure 8.1 shows the classification of cross asset portfolio derivatives within the
product group of trigger derivatives. The specific products mentioned denote examples
of the respective group.
Figure 8.1 The classification of trigger derivatives.

8.2. COLLATERALIZED OBLIGATIONS
This section provides an economic classification of cross asset portfolio derivatives

within the group of collateralized obligations, opposed to the structural classification
in Sec. 8.1. We also stress the risks involved and compare those with existing related
products in the context of collateralized obligations. We seek to introduce a simple
classification, focusing on the major parameters rather than on pure theoretical con-
structs.
We define collateralized obligations (CO) as structured and tranched investments
on an underlying pool of assets. Similar to trigger derivatives we distinguish CO with
respect to their underlying collateral. We call a structured and tranched investment on
an underlying pool of credit assets (e.g., bonds, loans, CDS, and credit-linked notes)
a collateralized debt obligation (CDO). Imposing CDO conventions on other asset
classes than debt, e.g., equity, foreign exchange, commodity, and fixed income, results
in a collateralized asset obligation (CAO).
At the next level, we consider the source of funds for the interest paid to the
investor of a CO. On the one hand, we have market value CO, where the underlying
collateral is a mark-to-market instrument. On the other hand, we have cash flow CO,
where the underlying collateral yields a periodic cash flow.
Funding is another criterion to classify CO and we distinguish between cash and
synthetic funding. The former involves a portfolio of cash assets as underlying and
the ownership of the assets is transferred to the legal entity (referred to as special
purpose vehicle) issuing the CO’s tranches. The reference assets of a synthetic CO are
not owned but swap-like. Using the above classification, a CTSO can alternatively be
defined as a synthetic cash flow CAO. Besides CTSO, there exists another class of CAO
referencing to other asset classes than credit, namely collateralized fund obligations
(CFO). However, as opposed to CTSO, a CFO is a market value cash CAO. Figure 8.2
shows the classification of CO regarding the distinctions made in Sec. 8.2.
8.3. A COMPARISON OF CFO WITH CTSO
At first glance, CFO and CTSO share many similarities, but the structural features as
well as the involved risks differ quite significantly. The following structural features
are presented in [3].
8.3.1. Structural Features of CFO

CFO have been known since the beginning of the 90s, referring to underlying indices
on a price level, e.g., commodity indices, hedge fund indices, or equity indices. We
assume CFO to fit especially the needs of real-money accounts that are interested in
180 Höcht et al.
Figure 8.2 The classification of CO.
new investment technologies based on asset classes, they are familiar with. Traditional
CFO, using equity and commodity indices as underlying, did not become as popular
as their counterparts: cash flow CO. In 2000–2001 CFO experienced a strong growth,
with hedge fund investments being included. The idea was to use a technology, which
generates benefits from a combination of highly volatile and uncorrelated trading
strategies (long-short equity, convertible arbitrage, event-driven, and fixed income
arbitrage). On the negative side, these CFO investments included multiple fees due to
the investment in tradable funds. According to [4], securitized hedge fund investments
can provide the following benefits:
• Attractive financing terms

• Transferability of existing portfolios of fund investments
• Diversification of the investor base by providing fixed income investors with market
exposure linked to hedge fund returns
• New opportunities for investors seeking leveraged returns in this asset class
In 2003–2004, according to [3], hedge fund-linked CFO activity slowed down due to
accounting issues. Still, market interest remained. The only innovative feature in these
transactions, compared to usual CO, was the use of an uncommon underlying.
8.3.2. Structural Features of CTSO

From the perspective of portfolio diversification, CTSO offer the opportunity to tap
the market for (correlated) trigger event risks. Tail events are the major risks in such
structures, while structural features as well as the unfunded nature of such transac-
tions are similar to the synthetic CDO market. Hence, this might be a favorable playing
field for hedge funds, proprietary desks, and insurance companies, given the in gen-
eral unfunded nature of the investments. The major characteristics of CTSO are the
following:
• Unfunded nature, trigger swaps as underlying
• Tail event risk as major risk factor
• Tail event correlation as major price input
• No waterfall principle necessary, due to the synthetic structure
8.3.3. The Different Risks

In general, while CFO are funded investments, CTSO are unfunded, i.e., swap-like.
Whereas the risk in a CFO transaction is basically market risk (volatility of the under-
lying), it is trigger event risk in case of a CTSO, due to the swap character of the
underlying. Hence, a CTSO and a CFO, referring to the same underlyings, bear a
different risk/return profile. One can construct a CFO which refers to specific mark-
to-market instruments such as commodity or equity indices. Using the corresponding
swap contracts (with some defined trigger event) on these indices as an underlying in
a CTSO, the risk profile of the transaction changes. While the CFO reacts highly sen-
sitive to daily mark-to-market changes in the underlying indices, a CTSO investment
better withstands small short-term price fluctuations, but is skewed to trigger events.
To sum up, the major difference between a CFO and a CTSO is that volatility is the
appropriate risk parameter in the former, and tail event risk (depending on the trigger
event of the underlying swap) is suitable to describe the risk profile of the latter.
8.3.4. Correlation of Tail Events in CTSO

Since the dependence of tail events is a major pricing input, one needs to stress specific
correlation assumptions. For example, in CCO, one might argue that specific macro-
economic shocks lead to a trigger event. Tail event correlation in different hedge funds,
for instance, is mostly linked to systematic, regulatory, and legal risks. Consequently,
a cross-asset CTSO offers the opportunity to benefit from (thus far) non-tradable asset
classes like inter-market tail event correlation.
The traditional correlation pattern between asset classes is changing in a cross
asset CTSO regime, with idiosyncratic risk factors losing in importance compared to
182 Höcht et al.
systematic risk factors. The risk/return profile of CTSO tranches differs significantly
from the one of the underlying assets, shifting risk away from volatility toward tail
events. The impact of changes in correlation depends on the specific tranche as the
following two examples illustrate:
(1) A long position in an equity piece of a CCO, where the trigger levels are set
below and above the current spot prices, is long in joint probabilities of large price
swings in the commodity market, i.e., the buyer of that piece expects rising joint
probabilities of large price movements.
(2) A short position in a senior piece of a cross asset CTSO is long in joint probabilities
of distortions in the underlying markets, i.e., the short seller expects the likelihood
of a market crash to rise.
Considering inter-market correlation is not new, but the securitization in terms of the
aforementioned products is. However, in order to derive the correlation of trigger events
in different financial markets, analyzing historical data is not sufficient. Mathematical
models, such as structural and/or copula-based models known from credit markets,
have to be implemented in order to get an intuition for the traded tail event correlations
in CTSO.
8.4. PRICING CROSS ASSET PORTFOLIO DERIVATIVES
8.4.1. Pricing Trigger Swaps

In the following, we introduce the basic notations of TS and state a pricing formula
for the annualized fair spread sf , which is also known as par spread. This spread is
computed such that both contractual parties can enter the TS at zero cost, i.e., without
upfront payment, at initiation.
• τ: the trigger time of the underlying

• N: the nominal of the TS
• RIR: the reimbursement rate of the TS
• s: the annualized spread of the TS
• T : the maturity of the contract
• rt : the deterministic term-structure of risk free interest rates
At initiation of the contract, a payment schedule T = {0 < t1 < · · · < tn = T } is

specified, where t0 = 0 is the settlement date. Assuming, for notational simplicity, the
usual (for credit derivatives) quarter-yearly premium payments, this implies tk = k/4
for k = 0, . . . , 4T and tk = tk − tk−1 = 1/4. For a given pricing measure Q and
the respective risk free interest rates rtk , continuously compounded, the value of the
expected discounted premium leg (EDPL) of the TS is obtained via:

n
EDPL = EQ N · s · tk · e−rtk tk 11{τ>tk }
k=1
N · s −rt tk
n
= e k Q(τ > tk ). (8.1)
4 k=1
The expected discounted trigger leg (EDTL) of the TS is given by

n
EDTL = EQ RIR · N e−rtk tk 11{tk−1 <τ≤tk }
k=1

n
= RIR · N e−rtk tk Q(tk−1 < τ ≤ tk ). (8.2)
k=1
Hence, from the perspective of the protection buyer, the expected value of a TS at
initiation of the contract is given by

n
N · s −rk tk
n
TS(0, T) = RIR · N e−rk tk Q(tk−1 < τ ≤ tk ) − e Q(τ > tk ).
4
k=1 k=1
The par spread sf , computed to allow both parties to enter the TS at zero cost, is found
by solving TS(0, T) = 0 for s, i.e.,
n −rtk tk
RIR k=1 e Q(tk−1 < τ ≤ tk )
sf = n −rtk tk
. (8.3)
1
4 k=1 e Q(τ > tk )
Equations (8.1) and (8.3) do not account for accrued interest, which might additionally
be included as part of the terms of contract. If accrued interest is stipulated, an additional
premium payment is added to the premium leg, which is proportional to the time
between the trigger event τ and the last payment date tk−1 and is conditional on the
event that the trigger falls into the respective period (tk−1 , tk ].
8.4.2. Pricing nth-to-Trigger Baskets

We consider a basket of I underlying TS and assume a pricing measure Q to be given.
If not stated differently, we assume the same reimbursement rate RIR for all under-
lying TS. The order statistic of the stochastically dependent trigger times τ1 , . . . , τI
is denoted by τ (1) ≤ · · · ≤ τ (n) ≤ · · · ≤ τ (I) . The expected discounted trigger and
184 Höcht et al.
premium legs of an nth-to trigger contract are given by

n

EDPL(n) = EQ N · s(n) · tk · e−rtk tk 11{τ (n) >tk }
k=1
N ·s (n)
n
= e−rtk tk Q(τ (n) > tk ), (8.4)
4 k=1

n
−rtk tk
EDTL (n)
= EQ RIR · N e 11{tk−1 <τ (n) ≤tk }
k=1

n
= RIR · N e−rtk tk Q(tk−1 < τ (n) ≤ tk ). (8.5)
k=1
The fair spread sf(n) is again obtained from equating both legs and solving for sf(n) . This
yields

(n) RIR nk=1 e−rtk tk Q(tk−1 < τ (n) ≤ tk )
sf = n −rtk tk
. (8.6)
1
4 k=1 e Q(τ (n) > tk )
8.4.3. Pricing CTSO

In what follows, we introduce a mathematical notation of the terms verbally explained
earlier in Example 1. Assume the CTSO portfolio consists of I TS contracts, indexed
by i. This portfolio is segmented in J tranches, indexed by j. The conventions regard-
ing the payment schedule are similar to the ones in the previous sections. Moreover,
we need
• TSi : a TS relating to underlying i

• τi : the trigger time of underlying i
• Ni : the nominal value of TSi
• RIRi : the reimbursement rate of underlying i
• lj , uj : the attachment and detachment point of tranche j
• M: the total nominal value of the CTSO
j
• Mt : the remaining nominal of tranche j at time t
• Lt : the cumulated loss of the CTSO portfolio up to time t
j
• Lt : the cumulated loss in tranche j up to time t
• j
s : the annualized spread of tranche j
For notational simplicity, the structure is simplified by assuming a homogeneous port-

folio with respect to the reimbursement rate and nominal of each TS, i.e., RIR = RIRi
and N = Ni for all i ∈ {1, . . . , I}. The crucial quantity for the description of all
payment streams is the portfolio-loss process Lt , which is defined as

I
Lt = RIR · N 11{τi ≤t} , t ∈ [0, T ]. (8.7)
i=1
The total nominal value of the CTSO is given by M = I · N. This nominal value is
segmented using the attachment and detachment point of each tranche. More precisely,
we define the partition 0 = l1 < u1 = l2 < · · · < uJ−1 = lJ < uJ = M. Based on
the overall portfolio loss, the loss affecting tranche j results in
j
Lt = min{max{0, Lt − lj }, uj − lj }, t ∈ [0, T ], j ∈ {1, . . . , J}. (8.8)
The remaining nominal of tranche j is determined by

j j
Mt = (uj − lj − Lt ), t ∈ [0, T ], j ∈ {1, . . . , J}. (8.9)
Given the payment schedule T = {0 = t0 < t1 < · · · < tn = T } and the pricing
measure Q, the expected discounted premium and trigger legs of tranche j are given by
n

−rtk tk j
EDPL = EQ
(j)
s · tk · e
(j)
Mtk , j ∈ {1, . . . , J}, (8.10)
k=1

n
−rtk tk j j
EDTL (j)
= EQ e (Ltk − Ltk−1 ) , j ∈ {1, . . . , J}. (8.11)
k=1
The fair spread of tranche j of the CTSO results in

n −rtk tk j j
EQ k=1 e (Lt k
− L tk−1
)
(j)
sf = , j ∈ {1, . . . , J}. (8.12)
n −rtk tk j
EQ k=1 tk · e Mtk
8.4.4. Modeling Approaches

For the pricing of derivatives on a portfolio (or basket) of TS, the joint distribution of all
trigger times (τ1 , . . . , τI ) is required. On a conceptual level, there are two methods to
incorporate dependence among the trigger times that seem promising for an adaption
from the world of credit derivatives to the current situation. In what follows, both
methodologies are introduced and discussed.
8.4.4.1. The structural approach

Dependence is introduced to the model by specifying a suitable I-dimensional stochas-
tic process. The univariate marginals either directly represent the respective under-
lying in the case of a traded asset, e.g., a stock index, or might be interpreted as
186 Höcht et al.
a proxy variable. An example for the latter is the firm-value interpretation used
in structural-default models. Typically, the trigger time τi is then defined as some
first-passage time of the respective univariate marginal below or above some trig-
ger level. Depending on the choice of univariate model, one has different options to
couple the marginals. For instance, if the univariate marginals are driven by Brow-
nian motions, a natural approach is to assume these Brownian components as being
correlated. If more general Lévy processes are used, common jumps might also be
used to introduce dependence. References for the modeling of stocks and credit prod-
ucts are [2] and [1]. References for the modeling of interest rates and energy, as
examples for other underlyings than stocks and credit, are the books [5] and [6],
respectively.
The major advantage of the structural approach is that it is fully dynamic, since all
relevant objects are modeled as marginals of one high-dimensional stochastic process.
Besides the static pricing of all univariate and portfolio derivatives at a time, this
additionally induces a dynamic which can be useful for the pricing of options on these
derivatives.
However, the structural approach has some drawbacks. Firstly, it is not obvious
how dependence shall be introduced to univariate processes from different model
classes, e.g., classical diffusions and pure jump processes. Secondly, analytically solv-
ing a non-trivial multi-dimensional first-passage time problem is virtually impossible.
This becomes evident when the example of [7] is considered, who succeeds in present-
ing a (highly non-trivial) formula for the joint probability of two correlated diffusions
to remain above some threshold level for a given time. Hence, pricing portfolio trigger
swaps requires a Monte Carlo engine, which is slow and biased if correlated processes
are sampled on a discrete grid and monitored for some threshold level. Thirdly, for
dependent stochastic processes, it is typically not possible to separate the parameters
of the marginals from those specifying the dependence structure; an exception are pro-
cesses purely driven by correlated Brownian motions. This complicates the calibration
of the model. Finally, the dependence structure of the resulting vector (τ1 , . . . , τI ) is
unknown for all non-trivial examples.
8.4.4.2. The copula approach

Combine the marginal distributions of the univariate trigger times by means of a
copula, i.e., by means of an I-dimensional distribution function on the unit I-cube.
Since an introduction to copulas is beyond the scope of this chapter, the interested
reader is referred to the textbooks [8]– [10]. The following approach was first used
in the context of credit risk-modelling by [11] and [12]. For each trigger time, it is
assumed that the (risk–neutral) marginal distribution is known and abbreviated as
Q(τi ≤ t) = p̄i (t) = 1 − pi (t). On a univariate level, each trigger time admits the
canonical construction
τi = inf{t ≥ 0 : pi (t) ≤ Ui }, Ui ∼ Uniform(0, 1). (8.13)
This representation is especially convenient for simulations, since sampling τi boils
down to sampling the univariate trigger variable Ui and solving, assuming a continuous
and strictly decreasing pi , pi (t) = Ui for t. Considering all random times τ1 , . . . , τt
at once it is possible to introduce dependence to the model by assuming the vector of
trigger times (U1 , . . . , UI ) to be distributed according to some I-dimensional copula
C. Note that, by the defining properties of a copula, it is guaranteed that the univariate
marginal distributions (of all τi ) are preserved, which is highly convenient in a cali-
bration. If sampling strategies for C are known, it is straightforward to sample from
the vector of random times (τ1 , . . . , τI ): sample (U1 , . . . , UI ) ∼ C and locate each
univariate trigger time τi .
The major advantage of the copula approach is the separation of marginals from
the dependence structure. Firstly, this allows the use of different model classes for
the univariate marginals. For instance, one might use a classical geometric Brownian
motion for one asset class, a pure-jump Lévy process for a second asset class, and
an intensity model for the asset class credit. For each of these classes, one can derive
univariate distributions for the respective τi ’s, which are then coupled by means of
the copula C. Using copulas with tail-dependence and singularities allows to include
Armageddon scenarios (with multiple trigger events at a time) and trigger clusters.
Secondly, the approach is well-suited for simulations, as long as sampling routines for
the copula are known. Thirdly, the calibration of the multivariate model is simplified
when the univariate marginals can be calibrated individually, followed by a calibration
of the dependence structure in a second step.
However, there are some shortfalls of the copula approach that need to be
addressed. Firstly, the model is static in the sense that a multivariate distribution of
(τ1 , . . . , τI ) is specified, but no dynamic model leading to it. While this is unprob-
lematic for pure pricing problems, it rules out applications such as the simulation of
the time evolution of resulting model spreads. Secondly, it is not clear which class of
copulas is best suited for modeling the dependence structure of the respective market.
As long as there is no liquid market for tail dependence, it is not clear which copula
should be preferred and how this copula should be parametrized.
Let us briefly give some references for the required sampling of copulas. In high
dimensions, sampling strategies for some elliptical copulas (including the Gauss-
and t-copula) are known, see e.g., [10]. For exchangeable (meaning that all pair-
wise correlations are identical) Archimedean copulas the standard reference is [13], an
important contribution is [14]. Recently, some authors considered hierarchical (nested)
Archimedean copulas and sampling strategies for these, see e.g., [15]– [17]. Sampling
Marshall–Olkin type copulas in high dimensions is considered in [18].
188 Höcht et al.
8.4.5. An Example for an nth-to Trigger Basket

In the following, we illustrate both pricing methodologies using an example for a
trigger derivative of medium complexity. Note that this example is more general than
cross asset trigger derivatives as introduced in Sec. 8.1, since it combines asset trigger
events with credit events.
Example 3 (An nth-to trigger basket over two asset classes). In this example, an
nth-to trigger basket consisting of six underlying TS is considered. The payment fre-
quency for premium payments is quarterly, the contract settles on 10 February 2009,
with a maturity of T = 5 years. The reimbursement rate is set to RIR = 50% for all TS
and for the CDS calibration. All TS contribute the same unit nominal to the portfolio.
(1) Stock indices:

• DAX 30, initial value S1,0 = 4636
• EuroStoxx 50, initial value S2,0 = 2338
• SMI, initial value S3,0 = 5219
An equity event is triggered when some index falls below a trigger level, which is
defined as 20% of the initial value, i.e., li = 0.2 · Si,0 .
(2) CDS:
• 5 year CDS on Allianz SE, initial spread 77.50 bps
• 5 year CDS on Linde AG, initial spread 90.00 bps
• 5 year CDS on E.ON N, initial spread 63.33 bps
Credit events are triggered according to the iTraxx CDS convention.
8.4.5.1. A pricing exercise of Example 3 (structural approach)

We model the evolution of each stock index i = 1, 2, 3 using a standard geometric
Brownian motion Si . Considering CDS spreads, we follow [19] and assume a simple
structural default model with geometric Brownian motion as firm-value process Vi and
monitor continuously for default. Since all processes have the same structure and are
driven by Brownian motions, it is natural to introduce dependence by assuming cor-
related Brownian components. Summarizing, we consider the vector-valued process
(S1,t , S2,t , S3,t , V1,t , V2,t , V3,t ), where under Q
dSi,t = Si,t (rdt + σS,i dWi,t

S
), Si,0 > 0, i = 1, 2, 3, (8.14)
dVi,t = Vi,t (rdt + V
σV,i dWi,t ), Vi,0 > 0, i = 1, 2, 3. (8.15)
All equity events are defined as τi = inf{t ≥ 0 : Si,t ≤ li }, where li = 0.2 · Si,0 for
the respective contract. Credit events are taken as τi = inf{t ≥ 0 : Vi,t ≤ di } for
some suitable default threshold di , i = 1, 2, 3. Solving the model via a Monte Carlo
simulation requires the following steps.
(1) Initialize the simulation, i.e., choose the number of simulation runs SR and the
grid-size .
(2) For each simulation run n = 1, . . . , SR do:
(a) Simulate the vector-valued process (S1,t , S2,t , S3,t , V1,t , V2,t , V3,t ) on the grid
0 < < 2 < · · · < T .
(b) At each point of the grid, monitor for eventual trigger times below (or above,
for other contract specifications) the equity or default thresholds, respectively.
(3) Compute and store the discounted premium and trigger leg of the current simula-
tion run n.
(4) Estimate the expected discounted premium and trigger leg as the arithmetic mean
of the legs in each run.
(5) Set the (estimated) fair spread as the quotient of the estimated trigger and premium
leg.
Note that such a continuous model might underestimate the risk of extreme (joint)
movements. This fact is well known in the univariate case, see e.g., Chapter 1 of [20],
and is further amplified for joint movements, due to a lack of tail dependence of the
multivariate normal distribution. To overcome this, one might try to use jump processes
instead of geometric Brownian motions.
8.4.5.2. A pricing exercise of Example 3 (copula approach)

We again model the evolution of each stock index using a standard geometric Brownian
motion. Considering CDS spreads, we use a simple reduced-form model with constant
default intensity. Since dependence is introduced in a second step by means of a copula,
we use independent processes of the form
dSi,t = Si,t (rdt + σS,i dWi,t

S
), Si,0 > 0, i = 1, 2, 3, (8.16)
to model the stocks under Q. All equity events are again defined as τi = inf{t ≥
0 : Si,t ≤ li }. Credit events are defined as τi = inf{t ≥ 0 : exp (−λi t) ≤ Ui },
where U1 , U2 , U3 are dependent (univariate uniform) triggers and λ1 , λ2 , λ3 denote
the (constant) default intensities. Solving the model via Monte Carlo requires the
following steps.
(1) Initialize the simulation, i.e., choose the number of simulation runs SR.
(2) For each stock index, compute survival probabilities Q(τi ≥ t) from the parameters
of the respective process. For this, the required probability of a Brownian motion
190 Höcht et al.
with drift not falling below some threshold level for a given amount of time is
given in [21], page 61.
(3) For each simulation run n = 1, . . . , SR do:
(a) Simulate the dependent trigger variables (U1S , . . . , U1C , . . . ) ∼ C.
(b) Compute the resulting trigger times.
(4) Compute and store the discounted premium and trigger leg of the current simula-
tion run n.
(5) Estimate the expected discounted premium and trigger leg as the arithmetic mean
of the legs in each run.
(6) Set the (estimated) fair spread as the quotient of the estimated trigger and premium
leg.
More details on the copula approach in the context of credit–risk modeling, including
asymptotic confidence intervals and the implementation of several nestedArchimedean
copulas, are given in [22].
8.4.5.3. Resulting model spreads

The input for our calibration are quotes obtained from Reuters on 10 February
2009 (2 p.m.). The continuously compounded interest rate is chosen as r = 0.024.
The marginals of the stock indices and individual stocks are calibrated as follows:
the parameter σS,i of stock index i is calibrated as implied volatility from out-of-
the-money put options. For this, a five-year maturity and strike close to li would
be ideal. Since these were not liquidly traded, we settled with a one year matu-
rity and a strike in the order of two-thirds of the initial value. The results are
(σS,1 , σS,2 , σS,3 ) = (38%, 38%, 31%) for the stock indices and (65%, 42%, 47%)
for the individual stocks. Note that these out-of-the money options typically trade at
a higher implied volatility compared to at-the-money options. The resulting trigger-
survival probabilities for the stock indices are (90%, 90%, 97%). Considering CDS
spreads, the stock price process is taken as a reference for the firm-value process and is
calibrated in the very same way as the stock index. In a second step, the default thresh-
old di is chosen such that the five-year CDS spread, being monotonically increasing
in di , is matched. Note that CDS spreads are computed under the simplifying assump-
tions of no accrued interest and a deterministic recovery rate R = (1 − RIR) = 50%.
Translated in terms of probabilities, this corresponds to a five-year implied survival
probability of about (92%, 91%, 94%), respectively, for the three companies. For the
copula approach, the marginal intensity λi for the ith CDS is similarly chosen such
that the intensity model matches the observed five-year CDS spread.
Since market prices of correlated tail risk are not (yet) observable, a calibration
to existing derivatives is not possible. Hence, we computed model prices for a large
spectrum of dependence structures. For this, we assumed a homogeneous correlation

ρ1 among each pair of stock processes and firm-value processes, i.e., dWi,t dWj,t =
d Ŵi,t d Ŵj,t = ρ1 dt, i = j, and a homogeneous correlation ρ2 < ρ1 among stocks and
firm-value processes, i.e., dWi,t d Ŵj,t = ρ2 dt, i ∈ {1, 2, 3}. For the copula framework,
we chose the Gauss copula with a block-matrix as correlation structure such that again
the groups stocks and credit are correlated with ρ1 , and stocks to credit are correlated
with ρ2 < ρ1 . Moreover, we included a partially nested Archimedean copula of the
Gumbel family, see [15] and [16]. We use two levels and three members in each of the
two (homogeneous) groups, i.e.,
C(u1 , . . . , u6 ) = C(C(u1 , u2 , u3 ; ψ1 ), C(u4 , u5 , u6 ; ψ1 ); ψ2 )

= ψ2 (ψ2−1 (ψ1 (ψ1−1 (u1 ) + ψ1−1 (u2 ) + ψ1−1 (u3 )))
+ ψ2−1 (ψ1 (ψ1−1 (u4 ) + ψ1−1 (u5 ) + ψ1−1 (u6 )))), ui ∈ [0, 1],
(8.17)
where ψi (t) = exp(−t 1/ϑi ) and ϑi ∈ [1, ∞), i = 1, 2. A sufficient condition for (8.17)
being a copula, is that the nodes ψ2−1 ◦ ψ1 have completely monotone derivatives. For
the nested Gumbel copula, this condition is equivalent to ϑ2 ≤ ϑ1 . NestedArchimedean
copulas might be interpreted as follows: any two members of the groups stocks and
credit are coupled via an inner Archimedean copula, and any two members of different
groups are coupled via an outer Archimedean copula. Nested Archimedean copulas are
appealing for the modeling of cross asset portfolio derivatives, since members of the
same asset class can be coupled via inner copulas, which are then connected via one
outer copula. For simplicity, we choose a single parameter ϑ1 for both groups (stocks
and credit) and a second parameter ϑ2 ≤ ϑ1 for the outer copula. This implies that the
dependence within a group is at least as large as the dependence among members of
different groups. The resulting model prices as functions of the dependence parameters
are presented in Figs. 8.3 through 8.5.
An interpretation of the resulting model spreads is given in what follows:
• An interesting observation is the monotonicity of spreads with respect to the depen-

dence ordering within a group (stocks and credit) and in between the groups. On a
qualitative level, these results are parallel for all pricing methods and therefore inter-
preted at once — ignoring minor differences. First-to-trigger spreads are decreasing
in dependence, which is consistent over all models and the two parameters of depen-
dence. The reason behind this observation is that multiple trigger events, but also
no trigger event at all, are more likely for a large correlation when trigger probabil-
ities are kept fix. The second-to-default spread is increasing in group dependence
but slowly decreasing in dependence among stocks and credit. The third-to-trigger
spread is increasing in group dependence and almost flat in extra-group dependence.
192 Höcht et al.
1st to trigger spread (in bps) 2nd to trigger spread (in bps)
1 1
350 140
0.8 0.8 130

300
120
0.6 0.6
110
ρ2
2
250
ρ
0.4 0.4 100
200
90
0.2 0.2
80
150
0 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
ρ1 ρ1
3rd to trigger spread (in bps) 4th to trigger spread (in bps)
1 1
70 50
0.8 0.8
60 40
0.6 50 0.6
30
ρ2
2
ρ
40
0.4 0.4
20
30
0.2 0.2 10
20
0 10 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
ρ1 ρ1
5th to trigger spread (in bps) 6th to trigger spread (in bps)
1 1
40
20
0.8 0.8
30
15
0.6 0.6
ρ2
2
ρ
20 10
0.4 0.4
10 5
0.2 0.2
0 0 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
ρ1 ρ1
Figure 8.3 Model spreads from the structural approach (25,000 runs).
The {4,5,6}th-to trigger spreads are all increasing in both dependence parameters,
since more dependence (of either sort) makes multiple defaults more likely, with
according influence on spreads.
• Comparing the structural approach and the Gauss-copula approach to the Gum-
bel copula shows that kth-to trigger spreads for higher k are much larger for the
latter. This is explained by the positive upper-tail dependence of the Gumbel family.
Heuristically speaking, this property means that the trigger variables Ui have a pos-
itive probability for being simultaneously close to one. Translated into the pricing
framework, this implies multiple trigger events within one simulation run, hence,
positive spreads for higher kth-to trigger spreads. Extending the simple structural
1 400 1
140
0.8 350 0.8 130
300 120
0.6 0.6
110
ρ2
ρ2
250
0.4 0.4 100
200 90
0.2 0.2
80
150
0 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
ρ1 ρ1
1 1
70 50
0.8 0.8
60
40
0.6 50 0.6
ρ2
ρ2
30
40
0.4 0.4
30 20
0.2 0.2
20 10
0 10 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
ρ1 ρ1
1 1
40
0.8 0.8 20
30
0.6 0.6 15
ρ2
ρ2
20 10
0.4 0.4
0.2 10 0.2 5
0 0 0
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8 1
ρ1 ρ1
Figure 8.4 Model spreads from the Gauss-copula model (250,000 runs).
model using jump processes might resemble this property. Another observation is
that spreads for the limiting case of independence agree within all models (up to a
small Monte Carlo noise).
• A final remark addresses the required computation time for both approaches. The
structural approach is based on the simulation of a path of a multivariate process
(on a fine grid) in each simulation run. Compared to the copula approach, which
only requires a sample from the respective copula in each run, it is therefore not
surprising that the computation time for the evaluation of one option price with
250,000 simulation runs differs massively. Our implementation in Matlab on a
standard PC requires about 3813 s for the structural and 11 and 18 s for the two
copula approaches, respectively.
194 Höcht et al.
2 2
1.8 350 1.8 110
1.6 1.6 100

300
ϑ2
ϑ2
1.4 1.4 90
250
1.2 1.2 80
1 200 1
1 1.2 1.4 1.6 1.8 2 1 1.2 1.4 1.6 1.8 2
ϑ1 ϑ1
2 60 2
40
1.8 50 1.8 35
30
1.6 1.6
40 25
ϑ2
ϑ2
1.4 1.4 20
30
15
1.2 1.2
20 10
5
1 1
1 1.2 1.4 1.6 1.8 2 1 1.2 1.4 1.6 1.8 2
ϑ1 ϑ1
2 2
30
1.8 25 1.8 15
1.6 20 1.6
10
ϑ2
ϑ2
15
1.4 1.4
10
5
1.2 1.2
5
1 1
1 1.2 1.4 1.6 1.8 2 1 1.2 1.4 1.6 1.8 2
ϑ1 ϑ 1
Figure 8.5 Model spreads from the Gumbel-copula model (250,000 runs).
8.5. OUTLOOK
Innovative instruments in the credit derivatives universe allow investors to construct

positions which refer to specific aspects of credit risk, e.g., spread volatility or
(correlated) default risk. While the standard valuation approach for these instruments
is still skewed to a pure transaction-driven style, i.e., ignoring interdependencies with
other instruments and markets, we expect the portfolio perspective to soon become
more important. For such a portfolio treatment, cross asset portfolio derivatives become
interesting. Allowing for collateralized products referring to other asset classes than
debt offers new opportunities for investments and risk management.
Cross asset portfolio derivatives typically smooth the risk/return profile of volatile
asset classes. Whereas the classical Capital Asset Pricing Model (CAPM) is still the
appropriate model to optimize the underlyings regarding return, risk, and correlation,
this portfolio management style changes in the case of cross asset portfolio deriva-
tives. In the CAPM world, the risk/return optimization is already implemented in the
market portfolio, which is defined as being efficient, while correlation between the
portfolio constituents is defined as the co-movement of asset prices. The individual
risk perception is simply reflected by the investment share of the market portfolio,
and the risk-free asset. In a cross asset portfolio derivatives world, the underlying
portfolio is selectable without the usual µ/σ-constraints. Correlation is rather joint
trigger probability and, e.g., the specific tranche investment in case of a CTSO is done
in line with the individual risk perception. Correlation, defined as co-movement of
assets, is replaced by the correlation of tail events, which induces a different view on
the risk/return optimization. Systematic shocks, like the sub-prime crisis starting in
2007, are a crucial risk factor for a cross asset portfolio derivative, whereas market
fluctuations and cyclical moves are of minor importance for the performance of such
derivatives.
To sum up, cross asset portfolio derivatives might be an interesting investment
product or portfolio management tool. There should not be any concerns regarding
demand/supply patterns. Both, demand and supply for tail event risk is immense,
given the huge variety of players in this market and, e.g., the recent financial crisis or
the rise/decline of the oil price. Traditional tail-event risk-driven companies (insurance
sector) are probably skewed to selling this kind of risk to players like hedge-funds,
banks, and fund managers, who can implement the attractive trading positions, but
also optimize the multi-asset portfolios, using cross asset trigger derivatives.
8.6. CONCLUSION
An extension of popular portfolio credit derivatives to more general trigger derivatives

is presented. The introduced class of cross asset portfolio trigger derivatives allows to
securize the risk of correlated tail events in the form of swap-like insurance claims. Two
pricing methodologies, transferred from the world of credit derivatives, are discussed
and illustrated by an example of medium complexity. It is shown how sensitive model
prices are with respect to the assumed concept of dependence. On the one hand, this
should be seen as a word of warning from the perspective of model risk. On the other
hand, one should keep in mind that typical cross asset portfolios contain exactly these
correlated tail risks. Hence, a securitization of correlated tail risks might be interesting
196 Höcht et al.
for both insurance seller and buyer. A standardized market of these derivatives would
then allow to calibrate the models to the market’s perception.
Acknowledgments
We thank Dr. Jochen Felsenheimer of Assenagon and Dr. Philip Gisdakis of UniCredit
MIB for their initial thoughts on this product group. Moreover, we thank Marius Hofert
(Universität Ulm) for valuable remarks on earlier versions of the manuscript. Views
expressed in this paper are those of the authors and do not necessarily reflect the
positions of the respective employers.
References
[1] Schönbucher, PJ (2003). Credit Derivatives Pricing Models: Models, Pricing and Imple-
mentation, 1st edn. Wiley Finance Series, John Wiley and Sons, Inc.
[2] Hull, J (2004). Options, Futures, and Other Derivatives. London: Prentice-Hall Interna-
tional, Inc.
[3] Felsenheimer, J (2006). The wonderful world of CAOs (strategy update). Technical report,
UniCredit MIB Global Credit Research.
[4] Standard and Poor’s (2006). CDO spotlight: Global criteria for securitizations of funds of
hedge funds. Standard and Poor’s, Structured Finance.
[5] Brigo, D and F Mercurio (2001). Interest Rate Models — Theory and Practice. Springer,
Finance, Berlin: Springer.
[6] Benth, FE, JS Benth and S Koekebakker (2008). Stochastic Modeling of Electricity and
Related Markets. World Scientific.
[7] Zhou, C (2001). An analysis of default correlations and multiple defaults. Review of Finan-
cial Studies, 14, 555–576.
[8] Joe, H (1997). Multivariate Models and Dependence Concepts. New York: Chapman &
Hall.
[9] Nelsen, RB (1998). An Introduction to Copulas, 1st edn. Berlin: Springer.
[10] McNeil, AJ, R Frey and P Embrechts (2005). Quantitative Risk Management. Princeton
Series in Finance, Princeton University Press.
[11] Li, DX (2000). On default correlation: A copula function approach. The Journal of Fixed
Income, 9(4), 43–54.
[12] Schönbucher, PJ and D Schubert (2001). Copula-dependent defaults in intensity models.
URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id= 301968. Working Paper.
[13] Marshall, AW and I Olkin (1988). Families of multivariate distributions. Jour-
nal of the American Statistical Association, 83(403), 834–841. URL http://www.
jstor.org/stable/pdfplus/2289314.pdf.
[14] McNeil, AJ and J Neslehova (2009). Multivariate Archimedean copulas, d-monotone func-
tions and l1-norm symmetric distributions. The Annals of Statistics, 37, 3059–3097.
[15] McNeil, AJ (2008). Sampling nested Archimedean copulas. Journal of Statistical Compu-
tation and Simulation, 78(6), 567–581.
[16] Hofert, M (2008). Sampling Archimedean copulas. Computational Statistics and Data
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[17] Hofert, M (2008). Efficiently sampling Archimedean copulas. Working Paper.

[18] Mai, JF and M Scherer (2009). Lévy-frailty copulas. Journal of Multivariate Analysis,
100(7), 1567–1585.
[19] Black, F and J Cox (1976). Valuing corporate securities: Some effects of bond indenture
provisions. Journal of Finance, 31, 351–367.
[20] Cont, R and P Tankov (2003). Financial Modelling with Jump Processes, 1st edn. Chap-
man & Hall/CRC Press.
[21] Musiela, M and M Rutkowski (2004). Martingale Methods in Financial Modelling
(Stochastic Modelling and Applied Probability). Springer.
[22] Hofert, M and M Scherer (2010). CDO pricing with nested Archimedean copulas. To
appear in Quantitative Finance.

Part II
Alternative Strategies

DYNAMIC PORTFOLIO INSURANCE

WITHOUT OPTIONS
9
DOMINIK DERSCH
Rumfordstr. 6, 80469 München, Germany
info@DominikDersch.de
Dynamic portfolio strategies are an interesting alternative to classical option-based

investment and protection strategies. One of the most prominent techniques is Con-
stant Proportion Portfolio Insurance (CPPI). In this chapter, we provide a review of
various techniques and formulate a general framework for investment and protection
strategies. The common feature of this strategy is that it empowers the investor to repli-
cate various option like pay-off profiles without the usage of options. These strategies
may replicate a simple floor type or advanced path-dependent look-back options that
implement all-time-high strategies with a given participation rate. We illustrate the
different strategies that employ features like various types of lock-in, trailing, lever-
age, and risky portfolio strategies with historical simulations. We include features
that allow the simulation under realistic market conditions taking into account trans-
action costs and the avoidance of excessive rebalancing through transaction filters.
We discuss the use of exchange traded funds (ETF) to invest in broadly diversified
multi-asset portfolios. The goal of this chapter was to illustrate different protection
strategies and to show how a practical implementation of these strategies could look
like. This chapter can serve as a guideline for simple spread-sheet models.
201
202 Dersch
9.1. INTRODUCTION
Institutional investors who require portfolio protection or a minimum absolute per-

formance target are facing the problem to trade off risk and return. On the one hand,
exposure to high return risky asset classes is desirable; on the other hand, the downside
potential that accompanies higher risk should be kept at the investor’s level of com-
fort. Holistically, the tasks of asset allocation and risk management are closely linked
and should not be performed in two separate steps, as this leaves the investor most
likely with sub-optimal solutions. However, a fairly large arsenal of risk management
techniques has been developed that work completely independent of the investment
strategy and respective asset classes. The sole requirements are that the asset classes are
investible and allow — at least in theory — a liquid market and continuous trading. The
selection of the underlying depends on the specific requirements of the investor with
respect to holding period, taxation, investment guidelines, etc., and the asset class
itself. Examples of different underlyings are direct investments in stocks or bonds,
futures, and funds. It is important to note that the investment universe and the respec-
tive protection strategy have to be closely aligned. Investments with large bid–offer
spreads would require a strategy with a low reallocation frequency.
For the sake of simplicity, this chapter focuses on this two-step approach described
above: Step 1 asset allocation, Step 2 risk management framework. Throughout this
chapter, the first step of asset allocation is simulated by investing in a set of indices.
The performance of each investment is assumed to follow the performance of the index
time-series. The considered investment universe includes stock, bond, commodity, and
hedge fund indices.
Our choice of the investment universe poses no restriction on the second step of
the investment process — the risk management framework. Within the fairly general
requirements of “investability” and liquidity, any asset classes and (propriety) trading
system may be embedded in this risk management framework.
The recent history of financial markets posed a huge challenge to portfolio man-
agers as reflected in massive declines in asset values, historical highs in volatility, and a
break down in correlations. Dynamic portfolio strategies are an interesting alternative
to classical option-based investment and protection strategies that allow one to cope
with the market turmoil. One of the most prominent techniques is Constant Proportion
Portfolio Insurance (CPPI) [2, 3]. CPPI went out of fashion because of a number of
drawbacks like the fixed time horizon, the inability to take profits and recover from
a major draw-down. One of the major shortcomings — the pro-cyclical behavior —
has been blamed for huge market movements and the stock market crash of 1987.
However, a number of advanced features allow one to overcome the shortcomings
of the first generation model and allow a practical application in asset management.
Dynamic Portfolio Insurance Without Options 203
A comparison of option-based strategies — mentioned above — and CPPI is shown

in [1].
The mature market for exchange traded funds (ETF) gives access to a huge universe
of different asset classes that may be traded with high liquidity and low bid–offer
spreads. This enables the investor to apply advanced portfolio insurance strategies as
described above and investment in a broadly diversified universe.
The remainder of this chapter is structured as follows. In the next two sections,
we review simple portfolio strategies and plain vanilla CPPI and illustrate them with
historical simulations. In Sec. 9.4, we formulate a more general framework of CPPI
with various features like different types of lock-in, trailing, leverage, and risky port-
folio rebalancing strategies. We include features that allow simulation under realistic
market conditions taking into account transaction costs and the avoidance of exces-
sive rebalancing through transaction filters. We further show that our framework also
includes an extension of CPPI named TIPP [4]. In Sec. 9.5, the strategies are illustrated
using historical simulations. In particular, we investigate how the different strategies
cope with the historical market evolution. In Sec. 9.6, we discuss the use of exchange-
traded funds (ETF) to implement protection strategies. This chapter concludes with
final remarks on different risk transfer mechanisms of option strategies versus dynamic
portfolio strategies.
9.2. SIMPLE STRATEGIES
9.2.1. Buy-and-Hold
Probably the most simple and most common risk management framework is the buy-
and-hold strategy. Not just among retail investors, either deliberately or not deliberately
buy-and-hold is a widespread approach. Many ambitious strategies will eventually drift
into passive sit-and-wait strategies as the investor sits out long periods of negative
performance or hesitates to take profits on time. Cheekily, buy-and-hold or strategic
trades very often stem from short-term tactical trades turned bad. The only reason why
this strategy remotely qualifies as some kind of protection strategy is that in the absence
of leverage the total loss is limited to the initial investment. However, buy-and-hold
has performed well over long periods and across many asset classes.
9.2.2. Stop-Loss
A stop-loss strategy is the first non-trivial step toward a risk management framework.
Here, we distinguish between an investment target IT on a present value base and a
target on a given time horizon T . In the first case, the position has to be switched into a
204 Dersch
risk-free investment matching the investment horizon if the portfolio value falls below
the target value at any time
PVportfolio (t) > IT . (9.1)
In the second case, the portfolio value must not fall below
PVportfolio (t) > e−r(T −t) · IT (9.2)
or equivalently
PVportfolio (t) − e−r(T −t) · IT > 0. (9.3)
Here, T − t is the time until the investment horizon is reached and r is the risk-free
rate of this time span. The second case is slightly more complex. Here, we must
ensure that the investor reaches his/her investment target at maturity. Therefore, the
portfolio value must not fall below a certain floor value given by the right hand side
of Eq. (9.2). In case, the stop-loss level is reached, the portfolio must be liquidated
and invested in the risk-free asset. Investing the floor value with the risk-free rate will
ensure the given target value at maturity. The implementation of a stop-loss strategy
requires monitoring both the portfolio performance and the total return of the risk-
free investment. The risk-free investment is usually implemented with treasury bills or
bonds with a maturity matching the investment horizon. The re-investment of coupons
paid until maturity must also be considered. In case, the stop-loss level is reached,
a single portfolio re-allocation occurs. Strictly speaking, stop-loss is therefore not a
dynamic strategy.
In the above analysis, we assume that the investments and the target level are in
the same consolidation currency. Otherwise, the respective FX spot or forward rates
have to be additionally monitored. Please note that a stop-loss strategy with a target
value of zero is the same as the above buy-and-hold strategy.
9.2.3. The Bond Floor Strategy

The stop-loss strategy bears the risk that the portfolio value may be exposed to large
volatility. In addition, it carries a short fall or gap risk. This is the risk that the stop
level is missed in large market movements and the investor is left with a final portfolio
value below the target. The bond floor strategy takes a more cautious approach. Here,
we only invest in the risky portfolio the amount we are willing to lose in the first place.
Let us take Eq. (9.3) at the beginning of the investment horizon
PV portfolio (t = t0 ) − e−rT · IT = C. (9.4)
C is the amount given by the difference between the initial investment and the present
value of the target amount. Here, we assume an investment in a risk-free bond with a
maturity matching the investment horizon. The bond floor strategy is usually imple-
mented with a target value close to 100%. According to the above equation, a given
investment of EUR 100, a target value of EUR 101 in one year, and a risk-free rate of
2.5% would leave us with a risk budget of EUR 1.5 and a bond investment of EUR 98.5.
That means EUR 1.5 is invested with a buy-and-hold strategy in a risky investment.
A total loss of the risky investment would still guarantee the target amount of 101 EUR
in one year. For a target value close to 100%, the bond floor strategy — as compared
to the stop-loss strategy — swings the pendulum in the other direction of extreme risk
aversion with the consequences of little upside potential beyond the target value. There
are two things worth mentioning: The bond floor must not be larger than the amount
that may be earned with the risk-free investment and a bond floor of zero is the same
as the above buy-and-hold strategy.
9.2.4. Plain Vanilla CPPI

CPPI tries to bridge the gap between high risk and high risk aversion of the above strate-
gies. The Constant Proportion Portfolio Insurance technique [2] was first introduced
by Black and Jones in 1987. It may be seen as a further generalization of stop-loss
and bond floor and it is literally a dynamic strategy. Similar to both strategies, a target
level and an investment horizon are given. In contrast to the bond floor strategy, we
assume that a total loss of the risky investment is highly unlikely. We rather accept
that the risky investment may fall by a factor of 1/M within a given time horizon. This
means that if we invest twice (e.g., M = 2) the amount given by the right hand side
of Eq. (9.3) in the risky portfolio, we still meet the investment target if the investment
will lose less than 50% of the initial value. This is the key idea of CPPI. The strategy
may be summarized by the following set of steps:
(1) Calculate the current risk budget C(t) similar to Eq. (9.4) according to
C(t) = PV portfolio (t) − e−r(H−t) · T, (9.5)
with PV portfolio (t = t0 ) = N0 .
(2) Calculate the exposure E(t) invested in the risky portfolio according to
E(t) = M · C(t). (9.6)
(3) Rebalance the portfolio by investing the amount E(t) in the risky portfolio and the
remaining amount in the risk-free investment.
(4) Wait until t has passed and go back to Step (2).
(5) Repeat the above steps until the end of the investment horizon T is reached. In
case C(t) according to Eq. (9.5) is zero, the portfolio will be allocated in the risk-
free investment until the end of the horizon. In that case, only the target value is
achieved.
206 Dersch
Table 9.1 Comparison of Simple Protection Strategies and Their Relation to CPPI.
Strategy Risk appetite Upside potential Short fall risk Relation to CPPI
Buy-and-hold High High No CPPI with zero

target
Stop-loss Medium, depends High, depends on Yes CPPI with very
on stop level stop level large multiplier
and target equal
to stop-loss level
Bond floor Low, depends on Low, depends on No CPPI with target
bond floor level bond floor level level equals bond
floor and
multiplier M = 1
CPPI Low, depends on Medium, depends Yes, but small Yes
target level on target level
Depending on the parameterization, CPPI allows one to implement a given risk

appetite: The larger the multiplier and the lower the target level, the higher the risk
appetite. It is easy to show that CPPI contains the above strategies buy-and-hold,
stop-loss, and bond floor for different settings of target level and multiplier.
The discounted target level is also called the floor
F(t) = E−r(T −t) · IT. (9.7)
The floor is the present value of the target.
Table 9.1 summarizes the risk and reward characteristics for the above strategies
and shows the link to CPPI.
9.3. HISTORICAL SIMULATION I
In this section, we show sample simulations for the above protection strategies. Our
risky portfolio is the Dow Jones Euro Stoxx 50. The simulation covers a period of
close to 10 years. For comparative reasons, we use similar protection levels where
applicable.
• Table 9.2 summarizes the simulation parameter.
• Figure 9.1 shows the buy-and-hold strategy.
• Figure 9.2 shows the stop-loss strategy.
• Figure 9.3 shows the bond floor strategy on the DJ Euro Stoxx 50 index.
• Figure 9.4 shows the CPPI strategy with a target level of 100% and a multiplier of
6. The floor is calculated using a discount rate of 3.25%.
• Table 9.3 summarizes the simulation results.
Table 9.2 Simulation Parameters of Simple Strategies.
Simulation period 4 January, 1999 — 12 December, 2008

Investment EUR 100 mn
Risk-free and risky investment EUR Overnight liquidity, DJ Euro Stoxx 50
Target 100% (except buy-and-hold)
Discount rate 3.25% (except buy-and-hold)
Multiplier 6 (CPPI only)
180
160
140
120
100
80
60
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.1 Buy-and-hold strategy on the DJ Euro Stoxx 50 performance index for an initial
portfolio value of EUR 100 mn. The performance of the portfolio (in EUR mn) is the performance
of the index.
In this market environment, the bond floor strategy seems to perform best over the
complete period both in the absolute return and the size of the worst draw-down. The
three other strategies all reach the same maximal portfolio amount of EUR 156.3 mn
(up 56%), but fail to benefit at maturity. The stop-loss and CPPI strategy show a very
similar picture. They are both stopped out during the sharp market decline in mid-2002
and realize a slight loss as compared to the initial portfolio value. This translates into
a slightly negative annual return of −0.17% (CPPI) and — 0.30% (stop-loss). Buy-
and-hold ranks last with respect to final portfolio amount annual return, and suffers
the worst portfolio draw-down of 65% of the previous all-time high value.
Stop-loss and CPPI both fail the target by a small amount. This may be due to two
reasons. The first is fundamental and is caused by rapid market movements when the
position may only be liquidated below the theoretical stop level. We can reduce this
fundamental risk by monitoring the position intraday. The second reason is caused by
a simplification of our simulation framework. Monitoring the stop-loss or floor level
requires one to monitor the zero coupon bond with a maturity equal to the remaining
208 Dersch
180
DJ EUR STOXX 50 risk-free
160
140
120
100
80
60
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.2 Stop-loss strategy on the DJ Euro Stoxx 50 performance index with a target level
of 100% at maturity. The risk-free investment is EUR overnight liquidity. The y-axis shows the
portfolio value in EUR mn.
160
DJ EUR STOXX 50 risk-free
140
120
100
80
60
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.3 Bond floor strategy on the DJ Euro Stoxx 50 index with a target level of 100% at
maturity. The risk-free investment is EUR overnight liquidity. The y-axis shows the portfolio
value in EUR mn.
investment horizon. As a simplification, a fixed discount rate is used in our simulation

framework to calculate the stop-loss level and floor. Our simplified risk-free investment
is EUR overnight liquidity rather than the corresponding zero bond with matching
investment horizon. We may fail to reach the target if the overnight investment fails to
earn — over the remaining investment horizon — the return implied by the floor level.
180
DJ EUR STOXX 50 risk-free floor
160
140
120
100
80
60
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.4 CPPI strategy on the DJ Euro Stoxx 50 performance index with a target level of
100% at maturity. The risk-free investment is EUR overnight liquidity. The floor (black line) is
assumed to follow an annual rate of 3.25%. The y-axis shows the portfolio value in EUR mn.
Table 9.3 Historical Simulation of Four Different Protection Strategies Using the
Dow Jones Euro Stoxx 50. We Calculate the Annual Return Over the Simulation
Period and the Worst Draw-Down. A Draw-Down of, e.g., 65% Means That the
Portfolio Lost 65% of Its Previous All-Time-High.
Strategy Buy-and-hold Stop loss Bond floor CPPI
Ann. return −1.69% −0.30% 2.03% −0.17%

Reached protection NA Yes No Yes
Worst draw-down 64.64% 48.47% 27.26% 47.34%
9.4. ADVANCED FEATURES
The above simulations illustrate different protection strategies. However, they are not
suitable for practical use for a number of reasons:
• Transaction costs may have an impact on the real world performance.

• Frequent rebalancing may cause excessive transaction costs and should therefore
be constrained by transaction filters.
• Investors require more sophisticated protection strategies like lock-in of gains.
• Investors may wish a leveraged exposure to the risky portfolio.
• For non-trivial risky portfolios, e.g., more than one risky asset, different rebalancing
strategies for the risky portfolio may be applied.
210 Dersch
In our simulation environment, we implemented a fairly general framework that takes

into account the above features.
9.4.1. Transaction Costs

Independent of asset classes and markets, transaction costs is a relevant factor that may
significantly impact the performance of a trading system. Trading systems that look
good on paper, e.g., paper trading, may fail in reality because transaction costs were not
considered. The impact of transaction costs is more dominant for frequent trading and
for long investment periods. The latter is important because of the compounding effect.
Transaction costs that reduce the portfolio amount in an early stage are no longer
available for future investment. The impact is hard to estimate and therefore has to be
simulated.
In our simulation environment, we model transaction costs as a percentage of the
transaction volume. Different transaction costs can be set for the risk-free and the risky
assets and for buying and selling the asset. The bid–offer spreads of ETF, for example,
vary widely from 2 bp to up to 100 bp depending on the asset class and time. This
corresponds to a transaction cost of 0.0001–0.005 times the transaction volume. The
transaction cost is only half because the bid–offer spread is paid on the full round trip
to get in and out of the asset.
9.4.2. Transaction Filter

With the ability to model transaction costs, the impact can be analyzed and optimized.
Here, we have to trade off flexibility versus rigidity — rapid adaptation to changes
in the market environment on the one hand with the downside of a large number of
transactions and high transaction costs. On the other hand, less frequent trading reduces
the transaction costs but poses the risk that the system is not flexible to respond to large
market moves. The introduction of transaction filters , λ, and t allows the investor
to trade off these two effects.
Strictly speaking a rebalancing in the plain vanilla CPPI is required whenever
Eq. (9.6) is violated. We calculate the deviation after time t = t + t has passed
according the following equation:
E(t)
1 − buy ≤ target ≤ 1 + sell . (9.8)
E (t)
A rebalancing is performed only if the target exposure Etarget (t) deviates from the
current exposure E(t) beyond the given boundaries. Typically, the parameter for buy
and sell are in the range of [0,0.2], with sell slightly smaller than buy , in order to react
quicker to a market downturn. Larger defines a higher threshold for rebalancing,
= 0 requires instant rebalancing.
The volatility filter λ scales the size of the rebalance — either buy or sell — if a
rebalancing is triggered according to Eq. (9.8).
E = λ · |Eold (t) − Enew (t)|, (9.9)
with λ in the range of [0.7,1.0]. For λ smaller than one, we follow only a fraction of
the rebalancing amount. The idea behind the volatility filter is that the market trades
in a range rather than follows a trend.
The re-observation period t is also a transaction filter: The larger t, the more
time elapses between a test of Eq. (9.8). The re-observation period has to be in line
with . Small and a large t or very close to one and small t do not fit well
together. Typically, t is in the range of one day. This implies that we test Eq. (9.8) at
close, but ignore intra-day movements outside the range defined by . This reflects the
observation that the intra-day volatility is typically larger than the day-to-day volatility.
9.4.3. Lock-in Levels

The plain vanilla CPPI does not protect any gains. To remedy this weakness, different
strategies to lock-in gains by raising the target level have been proposed. The obser-
vation period for lock-in may be given by t, its multiples (k · t), or by any other
discrete lock-in dates like every week or month.
To implement lock-in, we have to distinguish between the lock-in trigger and
the lock-in action. The trigger can be a simple trigger in time as described above, or
a trigger caused by a certain portfolio level or given by both. The different lock-in
actions are performed if a lock-in trigger is reached. They are summarized as follows:
• Discrete lock-in steps: X% gain in the portfolio amount is locked in by raising the
floor defined in Eq. (9.7). The discrete lock-in steps may refer to the fraction of the
initial notional at the beginning of the investment period, like every EUR 100,000
or to the notional at the previous lock-in level (compounding lock-in), like 10% of
the portfolio amount at the last lock-in.
• Newly reached all-time-high levels are locked in by raising the floor with respect to
the previous high level.
• Trailing: Y % gain in the portfolio amount is locked in by raising the target level
by the given gain. The discrete lock-in steps may refer to the initial target level
at the beginning of the investment period or refer to the previous lock-in level
(compounding lock-in).
• All-time-high trailing: Newly reached all-time-high levels are locked in by raising
the target level with respect to the previous high level.
The difference between the first two and the last two lock-in actions is that the lock-in
is applied to the floor level rather than the target level.
212 Dersch
The advantage of a lock-in is that gains that have been reached in the past are
protected. On the other hand, a lock-in may also cause a reduction in the exposure
due to a rising floor level and therefore limits participation in a future rise in the risky
portfolio.
9.4.4. Leverage and Constrain of Exposure

The lock-in levels discussed above support the requirement to protect gains in the risky
portfolio. On the other hand, investors may request further upside potential through
higher exposure to the risky portfolio. We may introduce leverage by rewriting Eq. (9.6)
E(t) = min{Emax (t), M · C(t)}. (9.10)
In the absence of leverage, we define
Emax (t) = PV portfolio (t). (9.11)
This means that the exposure to the risky portfolio may not be larger than the cur-
rent portfolio value. We cannot invest more than our current notional amount. More
generally, we may write
Emax (t) = K · PV portfolio (t). (9.12)
For K > 1, we allow leverage up to a certain level. For 0 < K < 1, we constrain the
maximum exposure to the risky portfolio. The latter has a similar effect as a lock-in. In
addition, we may scale Emax with respect to the initial investment PV (t0 ) rather than
the current portfolio value.
The leverage and constraint in the above description refer to the risky portfolio.
Similarly, we may define leverage with respect to the risk-free investment defined by
Riskfree(t) = max{Riskfreemin (t), PV portfolio (t) − E(t)}. (9.13)
In the absence of leverage, we find
Riskfreemin (t) = 0. (9.14)
This means that it is not allowed to borrow funds in order to invest in the risky portfolio.
More generally, we may write:
Riskfree(t) = k · PVportfolio (t). (9.15)
For k < 0, we allow borrowing and thus leverage up to a certain level. For 0 < k < 1,
we request a minimum amount to be invested in the risk-free asset, which constrains
the exposure to the risky portfolio. This has a similar effect as a lock-in. As proposed
above, we may also scale the risk-free exposure with respect to the initial investment
PV (t0 ) rather than the current portfolio value.
In our framework, we implemented leverage and constraint of the risky portfolio

and the risk-free asset. Both features may be used at the same time. The weaker criterion
determines the overall portfolio leverage or constraint.
9.4.5. Rebalancing Strategies for the Risky Portfolio

Up to now, we have not discussed how a rebalancing of the risky portfolio is propagated
to the portfolio constituents. In principle, we could perform a complete portfolio opti-
mization in each step and adjust the portfolio weights accordingly. This may include
Markowitz, VaR, or CVaR optimization with different types of linear, non-linear con-
straints, or boundary conditions. For the sake of simplicity, we show three types of
simple portfolio rebalancing strategies:
• Balanced: Here, the notional of all N risky portfolio constituencies is rebalanced in

accordance with the initial weights defined at the start of the strategy. This approach
reduces the amount of the above-average-performing risky assets and increases the
amount of the below-average-performing risky assets. The balanced approach is an
anti-cyclical profit-taking strategy that assumes a mean-reverting market within the
universe of the risky assets.
• Proportional: Here, the risky portfolio constituencies are rebalanced proportional to
current weights. This strategy implements a simple trend-following approach with
a soft competition among the risky assets.
• Squared: Here, the risky portfolio constituencies are rebalanced proportional to the
square of the current weight. Similar to the proportional strategy, this approach
implements a trend follower but with fierce competition among the risky assets due
to the squared-weighting factor.
9.4.6. CPPI and Beyond

The described framework allows implementation of a wide range of different strate-
gies customized to the risk appetite and investment guidelines of the investor. These
strategies are independent of the invested asset classes. The advanced features may
also make the simple strategies buy-and-hold, stop-loss, and bond floor more flexible.
When these strategies are extended from a static to a dynamic portfolio approach, the
transaction filters are also very useful.
The advanced features also offer the opportunity to remedy the weaknesses of
the original CPPI, like the lack of protecting gains, the fixed time horizon, and the
limited potential to recover from a large draw-down. The guaranteed target level at a
fixed time horizon is a feature that may not be necessarily required by an investor as
this requirement has also a significant downside: There is little upside potential to take
214 Dersch
advantage of a market recovery if the risk budget is strongly depleted after a downturn
in the risky portfolio.
The situation is worse if this happens in the early stage of the strategy. One pos-
sibility to remedy this weakness is the minimum exposure CPPI. Here, the allocation
in the risky portfolio is held at a minimum guaranteed level. This ensures participa-
tion over the complete lifetime of the strategy. But the participation comes at a cost.
An additional option has to be purchased to guarantee the target level at maturity. In
this chapter, we focus on portfolio strategies without options and therefore follow a
different approach.
If we forgo the requirement of a target level at a fixed time horizon, we can
instead attempt to secure — at any time — a fraction, e.g., 80% of a past portfolio
value. In our advanced CPPI framework, this approach can be implemented by setting
the discount rate in Eq. (9.7) to zero. Now target and floor are the same. In order to
provide a risk budget, the initial target value has to be below 100% of the notional
amount invested. Adding the lock-in type all-time-high trailing results in a strategy
that has been described as Time-Invariant Portfolio Protection (TIPP) [4]. The main
characteristics are
• No fixed investment horizon is required.

• Guaranteed instantaneous target level with an initial value below the investment
amount.
• Guarantee to recover from a market rebound because the risk-free portfolio contin-
uously generates a new risk budget.
• Implements a sequence of all-time-high look-back options with a participation rate,
which equals the target level but without the requirement of a fixed expiry date.
• The present value of the portfolio may fall with a growing investment horizon in
falling or sideward-moving markets.
The last point is a drawback of the approach. However, the investor can redeem the
investment at any time.
9.5. HISTORICAL SIMULATION II
In this section, we illustrate the above-advanced features with individual simulations

and analyze the impact on the performance in the current volatile market environment.
9.5.1. Transaction Costs and Transaction Filter

We mentioned above that it is important to include transaction costs in a simulation in
order to get an idea of the performance under realistic conditions.
Table 9.4 Simulation Parameters to Study the Impact of Transaction Filters

on Transaction Costs. Four Different Simulations are Carried Out.
Simulation period 4 January, 1999–26 December, 2006
Target 100%
Multiplier 3
Risk-free investment EUR overnight liquidity
Risky investment DJ Euro Stoxx Select Dividend 30
Discount rate 3.25%
Trans. filter (Sim. 1 and 3) (buy) = 0.12, (sell) = 0.08, λ = 0.85, t = 1 day
Trans. cost (Sim. 1 and 2) Risky investment 60 bp, risk-free investment 1 bp
In the following, we carry out four simulations with and without transaction fil-
ters combined with and without transaction costs. The risky asset is the DJ Euro Stoxx
Selected Dividend 30 index. The simulation parameters are summarized in Table 9.4.
To illustrate the impact of transaction costs, we selected a period of a rising market. The
transaction costs are set to 60 bp of the transaction volume for the risky investment and
to 1 bp for the risk-free investment. The transaction costs are deducted from the port-
folio at the time of the transaction. In our simulation, we ignore the effect of slippage
and partial execution. Figure 9.6 shows one out of the four simulations using transac-
tion filters and considering transaction costs. Table 9.5 summarizes a comparison of
different simulations with and without transaction filters and transaction cost.
Without the transaction filter, there is a huge impact of transaction costs. The
difference is EUR 54.45 mn. This means that the naïve approach — Simulation 4 —
would suffer a drop of more than 20% of the final portfolio value in case transac-
tion costs have to be taken into account (Simulation 2). Using the transaction filter
results in much smaller dependency on transaction costs. The difference here is only
Table 9.5 Comparison of Different Historical CPPI Simulations With (Without) Trans-
action Filters, Simulations 1 and 3 (Simulations 2 and 4) and With (Without) Transaction
Costs, Simulations 1 and 2 (Simulations 3 and 4). For the Different Combinations, We
Show the Total Number of Rebalancing Steps, the Portfolio Value at Maturity and the
Total Transaction Costs.
Trans. Trans. # of PV final in Transaction cost
Simulation filter costs transactions EUR (mn) in EUR (mn)
1 Yes Yes 66 230.64 −2.04

2 No Yes 1923 215.40 −8.84
3 Yes No 52 254.53 —
4 No No 1688 269.85 —
216 Dersch
EUR 23.90 mn (9.4%). The above simulation clearly reveals the damaging effect of
transaction cost in the absence of the transaction filter. There is a primary effect caused
by pure transaction costs that are deducted from the portfolio. This accounts for EUR
−2.04 mn (Simulation 1, with transaction filter) and EUR −8.84 mn (Simulation 2,
without transaction filter). There is a secondary effect that shows the total effect of
transaction cost. A comparison of the final portfolio values shows that in case of
transaction filters the difference between portfolio values of EUR −23.90 mn contains
transaction costs in the amount of EUR −2.04 mn. In the absence of transaction filters,
the performance gap is EUR −54.45 mn, where EUR 8.84 mn is the pure transaction
cost. In this context, the transaction cost ratio
PV (tc) − PV (ntc)
tcr = (9.16)
TC
is a useful ratio to measure the secondary effect of transaction cost. Here, PV (tc) is the
performance with transaction cost and PV (ntc) without transaction cost and TC the
pure transaction cost incurred over the observation period. A tcr close to one means
that the performance difference with and without transaction cost is mainly caused by
pure transaction cost. A tcr of two means that the transaction cost causes a performance
reduction of twice the amount of the pure transaction cost. In our simulation, the tcr
is equal to 11.71 (with transaction filter) and 6.16 (without transaction filter). The tcr
depends on the compounding effect and the leverage of exposure. In a CPPI simulation
with a multiplier of 3, every EUR of risk capital (cushion) changes the exposure to
the risky portfolio by EUR 3. Transaction costs that reduce the exposure early in
the investment period may have a tremendous impact on the performance later on.
Ironically, in a falling market, transaction costs may even have a positive impact in the
presence of a high multiplier as they may force the early reduction of the exposure and
save the portfolio from otherwise higher losses. We also found that if the floor level
is reached early in a simulation, transaction costs become less significant as it makes
no difference whether a further falling market or transaction costs are the cause for a
decline in portfolio value. In general, we conclude that the effect of transaction costs
is not very easy to estimate. Here, simulations shed light on the effect.
9.5.2. Lock-in Levels

The sample simulation of the simple strategies illustrated a fundamental drawback
of the protection strategies: the inability to take profits. An historical simulation on
the DJ Euro Stoxx 50 index illustrated how the gains of more than 50% that were
accumulated in the year 2000 are wiped out again (please compare Fig. 9.4). In order
to remedy this weakness, we introduced a number of different lock-in strategies that are
designed to protect gains. In this section, we perform historical simulations to evaluate
the performance of different lock-in strategies. In order to get a direct comparison, we
Table 9.6 Parameter Settings for Three Different Advanced CPPI Simulations. The
Simulation Parameters Differ only in the Discount Rate for the Floor, the Lock-In Trigger,
and Lock-In Action (the Last Three Rows).

Target 80%
Multiplier 6
Risk-free EUR overnight liquidity
Risky investment DJ Euro Stoxx 50
Transaction filter (buy) = 0.12, (sell) = 0.08, λ = 0.85, t = 1 day
Transaction cost Risky investment 8 bp, risk-free investment 1 bp
Discount rate 3.25% (Simulations 1 and 2), 0% (Simulation 3)
Lock-in trigger NA (Simulation 1, no lock-in), monthly, all-time-high (Simulations 2
and 3)
Lock-in action NA (Simulation 1, CPPI without lock-in), trail all-time-high by moving
up the floor (Simulations 2 and 3)
perform our simulation on the Dow Jones Euro Stoxx 50 index. Table 9.6 shows the
simulation parameters.
For comparative reasons, we first show the CPPI simulation without lock-in
(Fig. 9.5). As compared to the previous simulation shown in Fig. 9.4, we use a transac-
tion filter, consider transaction costs, and a target of only 80% as compared to 100%.
250
DJ EUR STOXX Select Dividend 30 risk-free floor
200
150
100
50
0
1999 2000 2001 2002 2003 2004 2005 2006
Figure 9.5 Historical CPPI simulation under realistic condition on the DJ Euro Stoxx Selected
Dividend 30 index using transaction filters and transaction costs. For a detailed specification,
please refer to the text above. The y-axis shows the portfolio value in EUR mn.
218 Dersch
180
160
140
120
100
80
60
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.6 Historical CPPI simulation on the DJ Euro Stoxx 50. The simulation parameters
are shown in Table 9.6. The areas show the allocation of the two assets. The black line is the
floor level. The y-axis shows the portfolio value in EUR mn.
Qualitatively, we find a similar result in Fig. 9.6 as before. The decline in the stock
market leads to a complete switch into the risk-free asset at the end of the investment
horizon. All previous gains are wiped out again. Due to the lower target of 80%, the
portfolio is still invested in the risky asset after the sharp decline in 2002 as compared
to a target level of 100%.
Figure 9.7 illustrates the impact of the all-time-high trailing. The floor is moved
upwards with a rising market. The initial target level of 80% trails the complete upward
market movement of 56%, resulting in a final portfolio amount of 133.8% of the initial
value. The simulation clearly demonstrates that trailing allows one to protect gains that
have been previously accumulated. The floor value is slightly missed for the reasons
already mentioned above.
As a consequence, the increased target level causes a complete exit from the risky
investment until the end of the investment horizon. The strategy protects gains, but is
unable to recover from the draw-down. This weakness is removed in the next simulation
shown in Fig. 9.8.
Compared to the previous simulation, we now discount the floor level with zero.
As a result, the floor is a horizontal line shifted upwards when new all-time-highs are
reached. The floor level marks the guarantee level. Discounting the floor with a rate of
zero reduces the risk budget because the floor is guaranteed instantaneously and not
at maturity.
The first half of the simulation period shown in Fig. 9.8 is similar to the simulation
in Fig. 9.7. The floor trails the rising index value and the following decline results in a
180
160
140
120
100
80
60
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.7 Historical CPPI simulation on the DJ Euro Stoxx 50 using the all-time-high trailing
with monthly lock-in triggers. The further simulation parameters are shown in Table 9.6. The
areas show the allocation of the two assets. The y-axis shows the portfolio value in EUR mn.
The black line is the floor level. The floor value is slightly missed for reasons mentioned above.
200
180
160
140
120
100
80
60
40
20
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.8 Historical CPPI simulation on the DJ Euro Stoxx 50. The simulation parameters
are shown in Table 9.6. The areas show the allocation of the two assets. The black line is the
floor level. The y-axis shows the portfolio value in EUR mn.
reallocation to the risk-free investment. Here, this reallocation occurs earlier because
of the reduced risk budget and we therefore do not reach the same all-time-high in
the portfolio value. The second half of the simulation shows a significantly different
picture as compared to Fig. 9.7. The strategy participates in the rising market starting
220 Dersch
in 2003. In 2005, the strategy is again allocated in the risky investment to a very high
proportion for a very short period of time. The guarantee level is moved upwards again.
As a result, we reach a final portfolio value of EUR 167.50 nm. For the given example,
the simulation shown in Fig. 9.8 is superior to the other strategies because of two
reasons:
• The ability to recover from the floor.

• The target value is guaranteed instantaneously and not at a pre-set maturity.
The reason for the rising from the dead like behavior of this strategy is the fact that
even on the floor the risk-free asset continuously regenerates a cushion. Supported by
a large multiplier, the exposure is quickly scaled up again. By the end of 2005, a new
all-time-high levels are reached. They are trailed with a participation rate which equals
the target level (80%).
Table 9.7 summarizes the results for the three different simulations. The TIPP
strategy performs best as compared to the two other strategies.
9.5.3. The Use of Leverage

Lock-in is a conservative feature. It allows the protection of past gains. On the other
hand, each lock-in reduces the risk budget and therefore may constrain future expo-
sure to the risky asset. Leverage has an opposite effect. It increases the exposure by
borrowing risk-free and investing it in the risky portfolio. It therefore allows a lever-
aged investment in the risky portfolio. In the following, we illustrate leverage with
one example on the Credit Suisse/Tremont Investable Hedge Fund Index. The index
consists of 60 different hedge funds that represent 10 different strategies. For more
information on the index, please see [6]. There exist institutional and retail products
on this index. Table 9.8 shows the parameter settings for this simulation. Please note
that the rebalancing frequency is monthly and we assume borrowing at the risk-free
overnight rate.
Table 9.7 Comparison of Different Historical CPPI Simulations With and Without
Lock-In (Columns 2 and 3) and with Lock-In and Flat Floor (Column 4). For the Three
Combinations, We Show the Portfolio Return, the Final Value and the Final Floor Value.
The Floor Value for Simulation 2 is Slightly Missed for the Reasons Mentioned Above.
Strategy (1) CPPI (2) CPPI with lock-in (3) TIPP: lock-in and flat floor
Ann. return −2.25% 2.97% 5.33%

End value EUR mn 79.76 133.78 167.53
Floor Final in % 80.00% 136.26% 166.80%
Table 9.8 Parameters for an Historical Advanced CPPI Simulation With Leverage.

Investment USD 1 mn
Target 80%
Multiplier 6
Risk-free USD overnight liquidity
Risky investment Credit Suisse Tremont Investable index
Transaction cost Risk-free investment 1 bp, risky investment 50 bp
Discount rate 0%
Lock-in trigger Portfolio PV increased by 10% of previous value tested on a monthly
base
Lock-in action Increase target by 10% of initial portfolio PV
Leverage Up to 60% of the initial investment of USD 1 mn may be borrowed at
any time to increase the exposure to the risky asset
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0 CS Trem. Inv. risk-free floor portfolio index

2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.9 Historical advanced CPPI simulation on the Credit Suisse Tremont Investable
Index. The y-axis shows the portfolio value in EUR mn. The leverage is limited to USD 0.6 mn.
The areas show the allocation of the two assets. Leverage shows up in a negative allocation of
the risk-free asset (light gray area). The gray-and-black-dashed lines are the performance of the
index and portfolio, respectively. The black line is the floor.
Figure 9.9 shows an historical simulation of the above strategy. The light gray
area represents the risk-free investment. Until 2008, we find a leveraged investment.
The allowed leverage of USD 600,000 is utilized to the maximum level at certain
times in 2000, 2005, 2006, 2007, and January 2008. Each increase of the target level
222 Dersch
(black line) is followed by a reduction of leverage. In this example, the leveraged

investment results in an outperformance of the hedge fund index (compare dashed
black line versus dashed gray line). That means that the proportion based on leverage
yields an additional positive return after borrowing and transaction costs.
The final portfolio value is USD 1.57 mn. This corresponds to an annual return
of 5.19%. The current floor level is USD 1.52 mn. There has been no short position in
the risk-free investment since October 2008. Currently, the portfolio still holds a 30%
investment in hedge funds. In this example, the lock-in feature mitigates the effect
of leverage. Without lock-in, the leverage budget of USD 600,000 mn would be fully
utilized from 2001 until the end of the simulation period. A higher leverage together
with lock-in would not make a significant difference as the lock-in and multiplier affect
the maximum amount to be borrowed (data for both simulations are not shown). This
emphasizes the requirement that strategy parameters are interdependent and have to
be carefully adjusted.
9.5.4. CPPI on a Multi-Asset Risky Portfolio

In this example, we illustrate a risky portfolio of different asset classes represented
by different performance indices, namely, equity (DAX), fixed income (Rex), and
commodities (Dow Jones AIG Commodity Index) classes. For the three assets, there
exist exchange-traded funds. The three asset classes have been selected based on the
low historical correlation of daily log-returns. In this example, we make use of the
portfolio rebalancing feature proportional. The simulation parameters are shown in
Table 9.9.
Table 9.9 Parameter Settings for an Historical Advanced CPPI Simulation

on a Multi Asset Portfolio Including the DAX, Rex, and Dow Jones AIG.

Target 80%
Multiplier 6
Risk-free EUR overnight liquidity,
Risky investment DAX (initial weight 30%),
Rex (initial weight 50%),
Dow Jones AIG Commodity (initial weight 20%)
Transaction cost Risky investment 20 bp, risk-free investment 1 bp
Discount rate 0%
Lock-in trigger Monthly, all-time-high
Lock-in action Trail all-time-high by moving up the floor
Rebalancing strategy Proportional
160
REX DAX risk-free DJ AIG Commodity Index floor
140
120
100
80
60
40
20
0
2000 2001 2002 2003 2004 2005 2006 2007 2008
Figure 9.10 Advanced historical CPPI simulation on a risky portfolio of three different low-
correlated asset classes. The four different shaded areas indicate the allocation over time. The
black line is the floor level.
Figure 9.10 illustrates how the allocations in different asset classes evolve over
time. From the end of 2000 until the beginning of 2005, the target level is constant.
There are two periods with a full investment in the risky asset (2000 and the end of 2004
until the end of 2005). The final portfolio value is EUR 131.32 mn. This corresponds to
a return of 3.0% p.a. mainly attributed to the years 2000 and 2005–2007. The present
value time weighted asset allocation is 45% Rex, 21% AIG Commodity Index, 17%
DAX, and 17% risk-free. This contrasts the current allocation of 22% Rex, 7% AIG
Commodity Index, 6% DAX, and 66% risk-free. This is intuitive as we are currently
very close to the floor level of EUR 123.95 mn.
9.6. IMPLEMENT A DYNAMIC PROTECTION

STRATEGY WITH ETF
The strategies shown in this chapter may be implemented by a direct investment in

shares or baskets of shares, bonds, or by an indirect investment via Futures. Exchange
Traded Funds (ETF) are an attractive alternative investment vehicle. ETF offers an
investment in a wide range of different asset classes. All sample investments used in
this chapter — except the Hedge Fund and Commodities index — may be implemented
by investing in a corresponding ETF. The ETF on the Dow Jones Stoxx Selected Divi-
dend 30 closely replicates the corresponding index. The index composition implements
a portfolio strategy in its own sense as the portfolio constituencies are dynamically
224 Dersch
Table 9.10 Comparison of Various Characteristics of ETF’s Please See Also [5].
Bid-offer Management
ETF ISIN spread in bp fee in bp pa
eb.rexx Goverm. Germany 5.5–10.5 DE 000 628 949 9 7 15

DJ Euro Stoxx 50 DE 000 593 395 6 8 15
DJ Stoxx 50 DE 000 593 394 9 43 50
DJ Euro Stoxx Select. Dividend 30 DE 000 263 528 1 56 30
DJ Stoxx Selected Dividend 30 DE 000 263 529 9 72 30
Dow Jones-AIG Commodity DE 000 A0H 0728 99 45
adjusted from the Dow Jones Stoxx 600 universe based on their dividend yield and
dividend consistency. For an exact definition of the index, please refer to the cor-
responding description of Dow Jones. Due to the nature of the index creation, the
portfolio follows a more conservative anti-cyclical profit-taking strategy. Generally,
the underlying rational of the index, its dynamic and characteristics have to be taken
into account when setting the parameters of the dynamic protection strategy. Table 9.10
compares typical bid–offer spreads and management fees of various ETF. The shown
bid–offer spreads are snapshots and may vary from day to day. For further information,
please compare [5].
Bid–offer spreads reflect the characteristics of the underlying and are influenced
among other factors by liquidity and taxation issues. Larger bid–offer spreads in the
investment would favor the transaction filter with larger , t, and small λ.
9.7. CLOSING REMARKS
We have demonstrated how the main drawback of CPPI, namely, its pro-cyclical behav-
ior, the lack of recovering potential once the floor has been hit, and the fixed investment
horizon can be overcome by introducing a number of advanced features. The above
strategies may be implemented with simple spread sheet models avoiding the usage
of options. However, the investor must be aware of the different risk aspects related to
this approach.
We illustrated how dynamic portfolio strategies empower an investor to replicate
fairly complex option profiles including path dependent look-back options. Under
certain conditions, the investor may save hedging costs, e.g., the option premium. But
the savings come at a price. The investor is left with the risk that the strategy will miss
the investment target. Buying an option allows one to lock in the implied volatility
at the time of purchase. If the realized volatility over the lifetime is higher than the
implied volatility of the option, the option is superior. Buying insurance — in the form
of options — is therefore fairly expensive in the current market environment; however,

if such a strategy was implemented one and a half years ago, an option-based strategy
back then looks very cheap now in terms of strikes and volatility.
Acknowledgment
The author is grateful to Thorsten Weinelt and UniCredit Research to support this
work, Peter Hieber for layout and formating, and to David Dakshaw for proof reading
the manuscript. Views expressed in this chapter are those of the author and do not
necessarily reflect positions of UniCredit Research.
References
[1] Bertrand, P and JL Prigent (2001). Portfolio insurance strategies: Obpi versus cppi. CERGY
Working Paper, 30.
[2] Black, F and R Jones (1987). Simplifying portfolio insurance. The Journal of Portfolio
Management, 14(1), 48–51.
[3] Black, F and AF Perold (1992). Theory of constant proportion portfolio insurance. Journal
of Economic Dynamics and Control, 16, 403–426.
[4] Estep, T and M Kritzman (1988). Tipp: Insurance without complexity. The Journal of
Portfolio Management, 14(4), 38–42.
[5] iShares (2008).
[6] Credit Suisse Tremont (2008).

10
HOW GOOD ARE PORTFOLIO
INSURANCE STRATEGIES?
SVEN BALDER∗ and ANTJE MAHAYNI†

Mercator School of Management,
University of Duisburg-Essen,
Lotharstr. 65, 47057 Duisburg, Germany
∗
sven.balder@uni-due.de
†
antje.mahayni@uni-due.de
Portfolio insurance strategies are designed to achieve a minimum level of wealth while
at the same time participating in upward moving markets. The most prominent exam-
ples of dynamic versions are option-based strategies with synthetic put and constant
proportion portfolio insurance strategies. It is well known that, in a Black/Scholes
type model setup, these strategies can be achieved as optimal solution by forcing an
exogenously given guarantee into the expected utility maximization problem of an
investor with CRRA utility function. The CPPI approach is attained by the introduc-
tion of a subsistence level, the OBPI approach stems from an additional constraint
on the terminal portfolio value. We bring these results together in order to explain
when and why OBPI strategies are better than CPPI strategies and vice versa. We
determine the utility losses, which are caused by introducing a terminal guarantee
into the unconstrained maximization approach. In addition, we focus on utility losses,
which are due to market frictions such as discrete-time trading, transaction costs, and
borrowing constraints.
227
228 Balder and Mahayni
10.1. INTRODUCTION
Portfolio strategies which are designed to limit downside risk and at the same time to
profit from rising markets are summarized in the class of portfolio insurance strate-
gies. Among others, [6] and [26] define a portfolio insurance trading strategy as a
strategy which guarantees a minimum level of wealth at a specified time horizon, but
also participates in the potential gains of a reference portfolio. Principally, one can
distinguish between two types of portfolio insurance strategies. A risky portfolio (or
benchmark index) is combined either with a risk-free asset or with a financial deriva-
tive. In particular, the first class includes dynamic versions of option-based portfolio
insurance (OBPI), stop-loss strategies, buy-and-hold strategies and constant propor-
tion portfolio insurance. The second class is mainly characterized by protective put
strategies, either in a static or rolling sense. Notice that, with the exception of the buy
and hold and the protective put, the above strategies are all dynamic in the sense that
they afford portfolio adjustments during the investment horizon. The concept of (syn-
thetic) option-based portfolio insurance is already introduced in [15] and [33]. The
constant proportion portfolio insurance (CPPI) is introduced in [12]. For the evolution
of portfolio insurance, we refer to [33].
The popularity of portfolio insurance strategies can be explained by various rea-
sons. On the side of institutional investors, there are regulatory requirements including
return guarantees as well as requisitions on the risk profile. For example, [1] considers
the problem of an institution optimally managing the market risk of a given exposure
by minimizing its Value-at-Risk using options. Amongst early papers on the optimality
of portfolio insurance are also [7] and [31]. More recently, [22] justifies the existence
of guarantees from the point of an investor through behavioral models. In particular,
they use cumulative prospect theory as an example, where guarantees can be explained
by a different treatment of gains and losses, i.e., losses are weighted more heavily than
gains, cf. [30] and [42].
Unfortunately, the justification of guarantees is less clear assuming that the
investor’s preferences can be described using the [43] framework of expected utility.
Dating back to [37], it is well known that in a Black/Scholes model setup and a constant
relative risk aversion (CRRA) utility function, the expected utility maximizing trading
rule is a constant mix strategy, i.e., a strategy where a constant fraction of wealth is
invested into the risky asset. In this case, an investment weight below one implies that
assets are bought when the asset price decreases. This is in sharp contrast to portfolio
insurance. In order to honor a terminal guarantee, the asset exposure is to be reduced if
the price of the risky asset decreases. Technically, it is straightforward to achieve CPPI
and OBPI strategies as the optimal solution of a modified utility maximization prob-
lem, which is based on an exogenously given guarantee. CPPI strategies are optimal for
an investor, who derives utility from the difference between the terminal strategy value
How Good are Portfolio Insurance Strategies? 229
and a given subsistence level. In contrast, the OBPI is optimal for a CRRA investor if
one exogenously adds the restriction that the terminal portfolio value is above the floor.
These results are well known in the literature. Without postulating completeness, we
refer to the works of [5, 6, 13, 16, 17, 21, 24, 26–28, 40, 41]. [20] considers the inverse
problem. They analyze if a specific dynamic strategy can be explained by solving the
maximization problem of an expected utility maximizing investor, i.e., they analyze if
a given investment strategy is consistent with expected utility maximization. In partic-
ular, they show that a strategy which implies a path-dependent payoff is not consistent
with utility maximization in a Black/Scholes-type model.
Another strand of the literature analyzes the robustness properties of stylized
strategies. Concerning the robustness of option hedges, we refer the reader to
[2, 8, 23, 25, 29, 34, 35]. The properties of continuous-time CPPI strategies are also
studied extensively in the literature, cf. [13] or [14]. A comparison of OBPI and CPPI
(in continuous time) is given in [9]. [44] also compares OBPI and CPPI strategies. In
particular, they derive parameter conditions implying second- and third-order stochas-
tic dominance of the CPPI strategy. The literature also deals with the effects of jump
processes, stochastic volatility models and extreme value approaches on the CPPI
method, cf. [10, 11]. An analysis of gap risk, i.e., the risk that the guarantee is vio-
lated, is provided in [3] and [19]. Gap risk is implied by introducing jumps into the
model or by market frictions such as discrete time trading. In practice, the gap risk
was already observable during the 1987 crash. In addition, the crash is sometimes even
explained or seen to be supported by the portfolio protection mechanisms. However,
there are also contradicting opinions, cf. [32]. Finally, there is also a a wide strand
of empirical papers, which measure the performance of portfolio insurance strategies.
For example, we refer to [18] who give an extensive simulation comparison of popular
dynamic strategies of asset allocation.
The following paper mitigates between expected utility maximization and the
comparison of stylized strategies. We start with an exposition of the three optimization
problems which imply constant mix, CPPI, and OBPI strategies as optimal. Instead of
giving a further justification for the existence of guarantees, we use the (well-known)
results of the optimization problems to explain the main differences between portfolio
insurance mechanisms. Comparing the terminal payoffs shows that both portfolio
insurance strategies, CPPI and OBPI, result in payoffs, which consist of a fraction of
the payoff of a constant mix strategy (which is optimal for the unconstrained CRRA
investor) and an additional term due to the guarantee. The additional term provides an
intuitive way to explain the main advantage of the OBPI approach as compared to the
CPPI approach. Intuitively, it is clear that the fraction of wealth which is put into the
optimal unconstrained strategy is linked to the price of the guarantee, i.e., the fraction
is less than one. In the case of the CPPI approach, the additional term is simply the
guarantee itself, i.e., the payoff of an adequate number of zero bonds. In contrast, the
additional term implied by the OBPI is a put option where the (synthetic) underlying is
given by a fraction of the constant mix strategy and the strike is equal to the guarantee.
Obviously, the put is cheaper than the zero bonds. Therefore, an investor who follows
the OBPI approach puts a larger fraction of his wealth into the unconstrained optimal
portfolio than an investor who follows the CPPI approach. To asses the utility costs of
forcing a guarantee into the unconstrained problem, i.e., the utility costs from having
to use a suboptimal strategy, we compare the certainty equivalents of the different
strategies and calculate the loss rates.
In addition, we explain one major drawback of the OBPI method, which is due to
the kink in the payoff-profile caused by the option component. The terminal value of
the OBPI is equal to the guarantee if the put expires in the money. In contrast to the
CPPI method, this implies a positive point mass for the event that the terminal value
is equal to the guarantee. The probability is given by the real world probability that
the terminal asset price is below the strike of the put. Intuitively, it is clear that this
can cause a high exposure to gap risk, i.e., the risk that the guarantee is violated, if
market frictions are introduced. We illustrate this effect by taking trading restrictions
and transaction costs into account. It turns out that the guarantee implied by the CPPI
method is relatively robust. In contrast, the probability that the guarantee is not reached
under the corresponding synthetic discrete-time OBPI strategy is rather high.
The outline of the paper is as follows. In Sec. 10.2, we review the well-known opti-
mization problems yielding constant mix, CPPI, and OBPI strategies as optimal solu-
tions. We compare the optimal strategies and resulting payoffs, and we discuss some
advantages (disadvantages) of the different portfolio insurance methods. In Sec. 10.3,
we consider the utility losses caused by the introduction of strictly positive terminal
guarantees for a CRRA investor. In particular, we compare CPPI and OBPI strategies
according to their implied loss rate. We consider the effects of market frictions in
Sec. 10.4 where we focus on the loss rates, which are implied by discrete-time trading
and transaction costs. In addition, we compare the effects of these market frictions on
the protection mechanisms of CPPI and OBPI. In Sec. 10.5, we address the topic of
borrowing constraints and consider the capped version of CPPI strategies. Section 10.6
concludes the chapter.
10.2. OPTIMAL PORTFOLIO SELECTION

WITH FINITE HORIZONS
All stochastic processes are defined on a stochastic basis (, F, F, P), which satisfies
the usual hypotheses. We consider two assets. The riskless zero bond B with maturity
T grows at a constant interest rate r, i.e., dBt = Bt rdt where BT = 1. The evolution
of the risky asset S, a stock or benchmark index, is given by a geometric Brownian
motion
dSt = St (µdt + σdWt ), S0 = s, (10.1)
where W = (Wt )0≤t≤T denotes a standard Brownian motion with respect to the real
world measure P. µ and σ are constants and we assume that µ > r ≥ 0 and σ > 0. In
particular,
dSt = St (rdt + σdWt∗ ), S0 = s, (10.2)
where W ∗ = (Wt∗ )0≤t≤T denotes a standard Brownian motion with respect to the
equivalent martingale measure Q, i.e.,

dQ 1 µ−r 2
= e− 2 ( σ ) t− σ Wt .
µ−r
(10.3)
dP t
A continuous-time investment strategy or saving plan for the interval [0, T ] can be
represented by a predictable process (πt )0≤t≤T . πt denotes the proportion of the port-
folio value at time t, which is invested in the risky asset S. In the following, we also
refer to πt as the portfolio weight at time t. W.l.o.g., we consider strategies which
are self-financing, i.e., money is neither injected nor withdrawn during the investment
horizon [0, T ]. Thus, the fraction of wealth which is invested at time t in the zero bond
B is given by 1 − πt . Let V = (Vt )0≤t≤T denote the portfolio value process associated
with the strategy π, then the dynamics of V are given by

dSt dBt
dVt (π) = Vt πt + (1 − πt ) where V0 = x. (10.4)
St Bt
For the above model assumptions, it follows
dVt (π) = Vt [(πt (µ − r) + r)dt + πt σdWt ] where V0 = x. (10.5)
Alternatively, the strategies can be represented by the number of shares. Let ϕt =
(ϕt,S , ϕt,B )0≤t≤T where ϕt,S denotes the number of risky assets and ϕt,B the number of
zero bonds with maturity T , which are held at time t. In particular, we have
πt Vt (1 − πt )Vt
ϕt,S = and ϕt,B = , (10.6)
St Bt
where Bt denotes the t-price of the zero bond maturing at T . Traditionally, a strategy
specification via the portfolio weights is used in the context of portfolio optimization
while the convention of stating the number of shares is normally preferred in the context
of hedging.
In the case of a finite investment horizon T and no intermediate consumption
possibilities, the relevant optimization problem is given by
sup EP [u(VT (π))] subject to Eq. (10.5), (10.7)
π∈
where denotes the set of all self-financing trading strategies. The utility function u
(u ∈ C2 ) is assumed to be strictly increasing and concave, i.e., u > 0 and u < 0. In the
following, we recall the well-known optimization problems, which justify three basic
strategy classes: constant mix (CM) strategies, constant proportion portfolio insurance
(CPPI) strategies, and option-based portfolio insurance (OBPI) strategies. In contrast
to a CM strategy, which is exclusively specified by a constant portfolio weight m, i.e.,
πtCM = m, portfolio insurance strategies incorporate a guarantee component which,
in the simplest case, is given by an amount GT , which is to be honored at the end of
the investment horizon T (T > 0). While a CPPI strategy is value-based in the sense
that the portfolio weights are exclusively specified by the current portfolio value (and
the present value of the guarantee), the (dynamic) OBPI approach is payoff and model
dependent. Here, the investment decisions are, in a complete model, given in terms of
the delta hedge of an option payoff. Formally, the three strategy classes are
CM = {π ∈ |πt = m, m ≥ 0} (10.8)

Vt − e−r(T −t) GT
CPPIG
= π ∈ πt = m ,m ≥ 0 (10.9)
Vt

t St
OBPIG = π ∈ πt = ,
Vt

∂
t = EQ [e−r(T −t) (h(ST ) − GT )+ |Ft ] . (10.10)
∂St
Notice that for GT = 0, we have CM = CPPI G . However, we refer to CPPI and OBPI
versions, where the guarantee is not a strategy parameter but GT > 0 is exogenously
given. In particular, we assume that GT < V0 erT .
For the OBPI approach, h is a functional which has to reflect the initial budget
constraint. In practice, h is typically a linear function of ST and the resulting payoff
equals a protective put strategy, where an initial investment in risky assets is protected
by corresponding puts. In general, h can be an arbitrary function, e.g., a power function.
In [39], a general discussion of how to choose h optimally with respect to different
utility functions is given.
Table 10.1 summarizes the optimization problems, which are suited to justify
the three strategy classes. Problem (A) is derived from the classic Merton problem,
Table 10.1 Benchmark Optimization Problems.
Problem Utility function (γ > 0, γ = 1) Additional constraint Optimal strategy

1−γ
(A) uA (VT ) = VT /(1 − γ) None CM
(B) uB (VT ) = (VT − GT )1−γ /(1 − γ) None CPPI
1−γ
(C) uA (VT ) = VT /(1 − γ) VT ≥ GT OBPI
cf. [37]. While Merton additionally considers optimal consumption, the optimization
problem (A) is limited to the terminal wealth. Nevertheless, due to the separability
of the investment and the consumption decision, the optimal investment strategy is
equal. Problem (B) introduces a subsistence level GT such that uB belongs to the
class of HARA utility functions. Problem (C) consists of the CRRA utility function
uA which is also used in problem (A) but poses an additional constraint on the ter-
minal value of the strategy, i.e., the constraint that the terminal strategy value must
be above or equal to the terminal guarantee GT . The solutions of the optimization
problems and their corresponding proofs are well known in the literature such that
we omit some technical parts of the proofs and refer to the literature given in the
introduction.
Intuitively, it is clear that the solutions of problems (B) and (C) are modifications
of the classic Merton problem (A), where a guarantee is exogenously forced into the
optimization problem, respectively the solution. Basically, the subsistence level in (B)
results in the optimization problem of (A) if the value process is reduced by the present
value of the terminal guarantee, i.e., the optimization problem (A) is given in terms
of the cushion process. Technically, the solution of problem (C) is more involved.
However, the solution of (C) is intuitive in the sense that the constraint on the terminal
value features an European option on the optimal payoff of (A), where the initial
investment must take into account the price of the option.
10.2.1. Problem (A)

Two observations simplify the optimization problem (A) to a large extend. (i), the con-
stant relative risk aversion implies that the attitude toward financial risk is independent
of the initial wealth level. (ii), the problem is independent of the current asset price St .
This follows from the stationarity of the increments of St . From (i), one can conclude
that the optimal terminal value VT (π∗ ) is linear with respect to the initial wealth. Let
V̂ 1 (t, T ) denote the optimal terminal value at T for current wealth Vt = 1. Consider
now two dates t1 < t2 . Then,
EP [uA (Vt2 (π∗ ))] = EP [EP [uA (Vt2 (π∗ ))|Vt1 (π∗ )]]
= EP [EP [uA (Vt1 (π∗ ) · V̂ 1 (t1 , t2 ))]|Vt1 (π∗ )]
= EP [uA (Vt1 (π∗ ))]EP [(V̂ 1 (t1 , t2 ))1−γ ],
i.e., the optimal portfolio weight in t < t1 must be equal for the two investment
horizons. This implies that the solution of problem (A) can be obtained by restricting
the strategy set to constant mix (CM) strategies such that it is enough to consider the
maximization problem
sup EP [uA (VT (π))] subject to Eq. (10.5).

π∈CM
Notice that for π ∈ CM , Eq. (10.5) simplifies to
dVtCM = VtCM [(r + m(µ − r))dt + mσdWt ] (10.11)

i.e., VTCM = V0CM e( r+m(µ−r)− 12 m2 σ 2 )T +mσWT . (10.12)
Inserting σWT = ln ST
S0
− (µ − 21 σ 2 )T gives
m
ST
V0CM e(m(µ−r)+r− 2 m σ )T −m(µ− 2 σ )T
1 2 2 1 2
VTCM =
S0
= φ(V0CM , m)STm (10.13)
where
m
1 1
e(1−m)(r+ 2 mσ )T .
2
φ(x, m) := x (10.14)
S0
Notice that, as a function of the terminal asset price ST , the payoff VTCM is concave for
m < 1, linear for m = 1 and convex for m > 1. The expected utility is equal to
φ(V0CM , m)1−γ (1−γ)m

EP [uA (VTCM )] = EP [ST ]
1−γ
(V0CM )1−γ (1−γ)(r+m(µ−r)− 1 γm2 σ 2 )T

= e 2 . (10.15)
1−γ
Finally, it is straightforward to show that
µ−r
argmaxm EP [uA (VTCM )] = =: m∗ . (10.16)
γσ 2
10.2.2. Problem (B)

Consider now the (modified) portfolio planning problem of an investor, who derives
the utility from the difference between the portfolio value and a given subsistence
level. Let C = (Ct )0≤t≤T denote the cushion process, where Ct := Vt − e−r(T −t) GT .
If a constant proportion m of the cushion is invested in the risky asset, one obtains
analogously to the Eqs. (10.11) and (10.13)
dCt = Ct [(r + m(µ − r))dt + mσdWt ], C0 = V0 − e−rT GT (10.17)

and
CT = φ(C0 , m)STm ,
as well as
argmaxm EP [uA (CT )] = argmaxm EP [uA (φ(C0 , m)STm )]

µ−r
= = m∗ .
γσ 2
Notice that EP [uA (CT )] = EP [uB (VT )]. Using the fact that the optimal payoff does
not depend on the asset price path (cf. for example [20]) implies that the optimal
∗
investment proportion πt,B of problem (B) is
∗ m∗ Ct m∗ (Vt − e−r(T −t) GT )

πt,B = = . (10.18)
Vt Vt
Obviously, problem (A) and (B) coincide in the case that GT = 0. However, GT > 0
implies a reduction in the investment proportion, i.e.,
∗
πt,B ≤ m∗ = πt,A
∗
. (10.19)
The cushion dynamics given by Eq. (10.17) immediately implies
Vt = e−r(T −t) GT + φ(C0 , m; t)Stm ,
i.e., Vt ≥ e−r(T −t) GT .
10.2.3. Problem (C)

The additional constraint VT ≥ GT together with the path-independency of the optimal
∗
solution implies that the optimal payoff VT,C can be represented as follows
∗
VT,C = max{h(ST ), GT }
= h(ST ) + [GT − h(ST )]+ = GT + [h(ST ) − GT ]+ . (10.20)
Thus, the terminal value of the strategy can be interpreted in terms of an option on the
payoff h such that the optimal strategy π∗ is given in terms of the delta hedge, i.e.,
π ∗ ∈ OBPI . In the special case that GT = 0, the optimization problem reduces to the
∗
classic Merton case, i.e., it holds h(ST ; GT = 0) = φ(V0 , m∗ )STm . For GT > 0, the
optimal solution affords a reduction of the initial investment from V0 to Ṽ0 (Ṽ0 < V0 )
∗
such that h(ST ) = φ(Ṽ0 , m∗ )STm . The remaining money V0 − Ṽ0 is then used to
buy the put with payoff [GT − h(ST )]+ . A proof for the optimality of the payoff
∗
∗
VT,C = GT + [φ(Ṽ0 , m∗ )STm − GT ]+ is given in [24]. The concavity of uA (x) =
(x1−γ )/(1 − γ) implies that for any payoff V̂T with V̂T ≥ GT
∗
uA (V̂T ) − uA (VT,C ) ≤ uA (VT,C
∗ ∗
)(V̂T − VT,C )


 ∗ −γ −γm
∗
∗ m∗ GT
φ(Ṽ0 , m ) ST (V̂T − VT,C ) for ST >

φ(Ṽ0 , m∗ )
= ,

 −γ GT

GT (V̂T − GT )
∗
for STm ≤
φ(Ṽ0 , m∗ )
i.e.,
∗ −γm∗
uA (V̂T ) − uA (VT,C ) ≤ φ(Ṽ0 , m∗ )−γ ST ∗
(V̂T − VT,C )
−γm∗ −γ
− (φ(Ṽ0 , m∗ )−γ ST − GT )+ (V̂T − GT ). (10.21)
∗
Now, consider a portfolio VT (ε) = εVT,A + (1 − ε)ṼT , where ṼT is the terminal
wealth of any other strategy with the same initial wealth. The first-order condition of
optimization problem (A) implies

∂EP [u(VT (ε))]
= EP [u (VT (ε))(VT,A
∗
− V˜T )]|ε=1
∂ε ε=1
−γm∗
= EP [φ(V0 , m∗ )−γ ST ∗
(VT,A − ṼT )] = 0.
∗
Therefore, adding and subtracting the optimal unconstrained solution VT,A to the first
term on the right hand side of inequality (10.21) and taking expectations gives
−γm∗ −γm∗
φ(Ṽ0 , m∗ )−γ (EP [ST ∗
(V̂T − VT,A )] + EP [ST ∗
(VT,A ∗
− VT,C )]) = 0.
∗ ∗
Together with V̂T ≥ GT a.s. it follows EP [uA (V̂T ) − uA (VT,C )] ≤ 0 such that VT,C is
indeed the optimal solution w.r.t. problem (C).
∗
∗
The payoff VT,C = GT + [φ(Ṽ0 , m∗ )STm − GT ]+ can be replicated by a self-
financing strategy where the initial investment can be represented by the expected
discounted payoff under the uniquely defined equivalent martingale measure Q, i.e.,
∗
V0 = e−rT EQ [GT + (φ(Ṽ0 , m∗ )STm − GT )+ ]

+
∗ GT
= e GT + φ(Ṽ0 , m )EQ e−rT STm −
−rT ∗
.
φ(Ṽ0 , m∗ )
Ṽ0 has to be determined such that the initial cushion C0 = V0 −e−rT GT exactly finances
φ(Ṽ0 , m∗ ) power call options with power p = m∗ and strike K = (GT )/(φ(Ṽ0 , m∗ )),
i.e.,

G
V0 − e−rT GT = φ(Ṽ0 , m∗ )PO 0, S0 ; m∗ , (10.22)
φ(Ṽ0 , m∗ )
where PO(t, St ; p, K) denotes the t-price of a power call with power p, strike K, and
maturity T . The pricing formula for power calls, cf. [45] or [36], is given by
PO(t, St ; p, K) := e−r(T −t) EQ [(ST − K)+ |Ft ]

p
 2 p
− (1−p)σ (T −t)
−r(T −t)  St e
2
= e
e−r(T −t)

St √
× N h1 t, √
p
− (1 − p)σ T − t
K

St
− KN h2 t, √ p
. (10.23)
K
N denotes the one-dimensional standard normal distribution function. The functions

h1 and h2 are given by
ln z + (r + 12 σ 2 )(T − t) √
h1 (t, z) = √ ; h2 (t, z) = h1 (t, z) − σ T − t. (10.24)
σ T −t
∗
Recall that Ṽ0 ≤ V0 . A lower bound on Ṽ0 follows with [STm − GT /φ(Ṽ0 , m∗ )]+ ≤
∗
STm , i.e.,

G ∗
φ(Ṽ0 , m∗ )PO 0, S0 ; m∗ , ≤ φ(Ṽ0 , m∗ )EQ [e−rT STm ] = Ṽ0
φ(Ṽ0 , m∗ )
and Eq. (10.22). This implies
V0 − e−rT GT ≤ Ṽ0 ≤ V0 . (10.25)
∗
Consider now the optimal portfolio weight πt,C of the dynamic strategy, i.e.,

φ(Ṽ0 , m∗ )PO t, St ; m∗ , φ(ṼG,m
T
∗)
St
∗
πt,C = 0
Vt

φ(Ṽ0 , m∗ )PO t, St ; m∗ , φ(ṼG,m
T
∗)
St
= 0
, (10.26)
e−r(T −t) GT + φ(Ṽ0 , m∗ )PO t, St ; m∗ , φ(ṼG,m∗ )
0
where PO := ∂PO

∂St
(t, St ; p, K). Differentiating (10.23) immediately gives
σ2
p−1
St e 2 p(T −t) St √
PO
(t, St ; p, K) = p N h1 t, √ − (1 − p)σ T − t .
e−r(T −t) p
K
(10.27)
Finally, we compare the optimal investment weight implied by problem (C) with the
one of the unconstrained solution given by m∗ . Notice that
+
∗ GT ∗ GT
STm − ≥ STm −
φ(Ṽ0 , m∗ ) φ(Ṽ0 , m∗ )
implies that the denominator of the right hand side of Eq. (10.26) is larger than
∗ ∗ ∗
−1)(r+ 12 m∗ σ 2 )(T −t)
φ(Ṽ0 , m∗ )EQ [e−r(T −t) STm |Ft ] = φ(Ṽ0 , m∗ )Stm e(m
such that

∗ GT ∗ ∗ 1 ∗ 2
πt,C ≤ PO t, St ; m∗ , St(1−m ) e(1−m )(r+ 2 m σ )(T −t) .
φ(Ṽ0 , m∗ )
In addition, Eq. (10.27) immediately gives
m∗ −1
∗ GT ∗ St ∗
(1−m∗ )σ 2 (T −t)
e− 2 m
1
PO
t, St ; m , ≤m .
φ(Ṽ0 , m∗ ) e−r(T −t)
Together, we have
∗
πt,C ≤ m∗ . (10.28)
Analogously to the problem (B), the terminal constraint in problem (C) also gives rise
to a reduction of the optimal unconstrained portfolio weight m∗ .
10.2.4. Comparison of Optimal Solutions

Recall that the optimal terminal payoffs VT∗ do not depend on the asset price path, but
can be specified as a function of the terminal asset price ST . The optimal payoffs for
the optimization problems (A), (B), and (C) are summarized as follows
∗
∗
VT,A = φ(V0 , m∗ )STm (10.29)
∗
∗
VT,B = GT + φ(V0 − e−rT GT , m∗ )STm
V0 − e−rT GT ∗
= GT + VT,A (10.30)
V0
∗
∗ +
VT,C = GT + φ(Ṽ0 , m∗ )STm − GT (10.31)
∗ ∗
= φ(Ṽ0 , m∗ )STm + [GT − φ(Ṽ0 , m∗ )STm ]+

+
Ṽ0 ∗ Ṽ0 ∗
= V + GT − VT,A . (10.32)
V0 T,A V0
∗
The payoff VT,A corresponds to φ(V0 , m∗ ) power claims with power m∗ , where the
∗
number φ(V0 , m ) depends on the initial investment and the optimal investment weight
m∗ . The optimization problem (B) introduces a subsistence level which implies that
the number of power claims with power m∗ must be reduced to afford the risk-free
investment, which is necessary to honor the guarantee. In consequence, the portfolio
weight is lower than in the case of problem (A), cf. Inequality (10.19). The link between
the solutions of (A) and (B) is even more explicit if one considers the number of shares
in the asset which are held. Notice that the cushion dynamics, cf. Eq. (10.17) implies
that CtCPPI /C0CPPI = VtCM /V0 if the multiplier m of the CPPI is equal to the portfolio
weight of the CM strategy. In particular, this implies that the value of the cushion is
proportional to the value of the CM strategy, i.e., CtCPPI = (C0 /V0 )VtCM . This is also
true for the number of assets ϕt,S , i.e.,
C0 CM
CPPI
ϕt,S = ϕ (10.33)
V0 t,S
C0 CM
CPPI
ϕt,B = GT + ϕ , (10.34)
V0 t,B
where ϕt,B denotes the number of zero bonds with maturity T . In particular, it holds that
C0 CM
VtCPPI = e−r(T −t) GT + V . (10.35)
V0 t
The CPPI strategy can thus be interpreted as a buy-and-hold strategy of a constant
mix strategy with an additional investment into GT zero bonds, cf. also Eq. (10.31). A
similar reasoning applies to the solution of (C), which can be interpreted as a buy-and-
hold strategy of a constant mix strategy with an additional investment into a put with
strike GT , cf. Eq. (10.32). Obviously, the put is worth less than GT zero bonds such
that one can buy and hold more CM strategies in the case of the option based approach,
i.e., Ṽ0 /V0 ≥ C0 /V0 . Intuitively, it is thus clear that the OBPI approach gives a better
result than the CPPI approach with respect to a utility function, which favors the CM
strategy with portfolio weight m∗ .
∗
In general, a modification of the payoff VT,A which honors the guarantee GT and
with t0 -price equal to V0 can be represented by
+
+
∗ G G
subject to EQ e−rT GT + α VT,A ∗
T T
GT + α VT,A −β −β = V0 .
α α
(10.36)
The CPPI approach corresponds to β = 0 and gives a smooth payoff-profile. β = 1

results in the OBPI approach with a kinked payoff-profile. As a consequence of the
∗ ∗ ∗
guarantee GT , both payoffs VT,B and VT,C are higher (lower) than VT,A for low (high)
∗
terminal asset prices. However, the smooth solution VT,B implies that the intersec-
∗ ∗
tion with VT,A occurs at a higher asset price ST if compared to the intersection of VT,C
∗
and VT,A . Let si,j (i = j, i, j ∈ {A, B, C}) denote the terminal asset price ST such that
∗ ∗
VT,i = VT,j . Equation (10.30) immediately gives
∗ ∗ ∗
VT,A = VT,B ⇔ VT,A = V0 erT
such that
1
sA,B = S0 e(r+ 2 (m−1)σ )T .
2
(10.37)
With Eq. (10.32), Ṽ0 ≤ V0 and V0 ≥ e−rT GT it follows

1 1 2 1
sA,C = S0 e m (g−r)T e(r+ 2 (m−1)σ )T
= e m (g−r)T sA,B (10.38)
where g := T −1 (ln GT − ln V0 ) ≤ r. Finally, one obtains

1 1 1
sB,C = S0 e m (ν−r)T e(r+ 2 (m−1)σ )T = e m (ν−r)T sA,B
2
(10.39)
where ν := T −1 (ln GT − ln(Ṽ0 − C0 )) ≥ r. Therefore sA,C ≤ sA,B ≤ sB,C . An

illustration of the payoffs and the intersection points is given in Fig. 10.1.
Table 10.2 Basic Parameter Constellation.

Model paramter Strategy parameter Terminal guarantee
S0 = 1 V0 = 1
σ = 0.15 T = 10 GT = 1
r = 0.03 γ = 1.2
µ = 0.085 m = m∗ = 2.037
3
Payoff
0
0.0 0.5 1.0 1.5 2.0 2.5 3.0
Terminal asset price
Figure 10.1 Optimal payoffs VT,A ∗ (solid line), V ∗ (dotted line), and V ∗ (dashed line),
T,B T,C
where the parameters are given as in Table 10.2.
We end this section by emphasizing one important consequence for the two pro-
tection mechanisms implied by the smooth and the kinked solutions, i.e., implied by
the assumptions that marginal utility jumps gradually or discontinuously to infinity.
∗
Notice that the smooth payoff VT,B implies that there is no probability mass on the
∗
event that the terminal value is equal to the guarantee GT , i.e., P(VT,B = GT ) = 0. In
∗
contrast, for the kinked payoff VT,C , it holds

∗ m∗ GT
P(VT,C = GT ) = P ST ≤
φ(Ṽ0 , m∗ )
 
m∗ GT
 ST φ(Ṽ0 ,m∗ ) 
= P ln ≤ ln . (10.40)
S0 S0
Using the definition of φ, cf. Eq. (10.14), and m∗ = (µ − r)/(γσ 2 ) yields

 2 
ln e−rTṼ0GT − 12 γλ T √ 
∗ 
P(VT,C = GT ) = 1 − N  λ
√ + λ T, (10.41)
γ
T
where λ := (µ − r)/σ.
Intuitively, it is clear that a positive point mass on the event {VT = GT } might
indicate that the corresponding strategy is more sensitive to the introduction of gap
risk, which is caused by asset price jumps. This problem is considered in Sec. 10.4,
where trading restrictions in the sense of discrete time trading and transaction costs
are introduced.
10.3. UTILITY LOSS CAUSED BY GUARANTEES
10.3.1. Justification of Guarantees and Empirical Observations

There are a few comments necessary concerning the justification of guarantees. The
optimization problems (B) and (C) are already based on an exogenously postulated
guarantee such that one might doubt their capacity to give a meaningful justification
of guarantees. However, there are some arguments, which are in favor of a subsistence
level. Similar reasonings are true with respect to optimization problem (C). In conse-
quence, to some extent, guarantees can be explained with respect to the assumption
that the investor’s preferences can be described using the [43] framework of expected
utility. More recently, [22] justifies the existence of guarantees through behavioral
models. In particular, they use cumulative prospect theory as an example.
In the following, we do not give further justifications for the existence of guarantees
or the popularity of portfolio insurance strategies but take them as given. However,
we think in terms of utility losses caused by guarantees and compare the smooth and
kinked payoff solutions. One possibility which is consistent with empirical observations
is given by measuring the utility losses of guarantees with respect to a CRRA utility
function, where the parameter of risk aversion is assumed to be above 1 (γ > 1). For
the validity of CRRA utility functions and the parameter of risk aversion, we refer
to [38] and the literature given herein.
10.3.2. Utility Loss

The performance of the strategy π can be measured by its associated expected utility,
which can in turn be described by the certainty equivalent. It is defined as the certain
amount, which makes the investor indifferent between achieving this certain amount
(at T ) or using the strategy π, i.e., the time T certainty equivalent CET of the strategy
π is defined by
u(CET (π)) = EP [u(VT (π))]. (10.42)
Consider for example the utility function uA (x) = x1−γ /(1 − γ) and a CM strategy
with optimal investment proportion m∗ , i.e.,
(1−γ)m∗ 1
CE T,A (πCM ) = φ(V0 , m∗ )(EP [ST ]) 1−γ . (10.43)
p p
With EP [ST ] = S0 exp{(pµ − 12 p(1 − p)σ 2 )T } it follows
∗ ∗
µ− 12 γσ 2 m∗ (1−m∗ (1−γ)))T
CET,A (πCM ) = φ(V0 , m∗ )S0m e(m
∗
(µ−r)− 12 γ(m∗ )2 σ 2 )T
= V0 e(r+m
1 µ−r 2
= V0 erT e 2γ ( σ
) T
. (10.44)
Analogously, one obtains

∗
(µ−r)− 12 γ(m∗ )2 σ 2 )T
CE T,B (πCPPI ) = GT + (V0 − e−rT GT )e(r+m
1 µ−r 2
= CE T,A (πCM ) + GT (1 − e 2γ ( σ
) T
). (10.45)
Thus, the certainty equivalent is lower for an investor with subsistence level than an
investor without. We can also calculate the utility loss of an investor, who follows a
suboptimal strategy. It is described by the loss rate lT,i (π) of the strategy π and the
utility function i (i ∈ {A, B, C}) where
∗
CET,i
ln CET,i (π)
lT,i (π) := . (10.46)
T
CE ∗T,i denotes the certainty equivalent of the optimal strategy πi∗ = (πt,i ∗
)0≤t≤T while
CE T,i (π) the one of the suboptimal strategy π = (πt )0≤t≤T .
The loss rates with respect to the utility function uA (x) = x1−γ /(1 − γ) are
summarized in Table 10.3 for CM, CPPI, and OBPI strategies with strategy parameter
m. Notice that a loss rate, which is higher than the one of a risk-free investment, i.e.,
πtCM = 0, implies that the associated strategy is prohibitively bad. This critical loss
rate is equal to 12 γ(σm∗ )2 , cf. Table 10.3. For m = m∗ , it is obvious that lT,A (πOBPI ) <
lT,A (πCPPI ) because πCPPI is suboptimal w.r.t. the optimization problem (C) where
Table 10.3 Loss Rates with Respect to uA (x) = x 1−γ /(1 − γ ).
Strategy π Loss rate lT,A (π)

1 2 ∗ 2
πtCM = m γσ m − m
2
∗
Vt − e−r(T −t) GT 1 EP [(φ(V0 , m∗ )STm )1−γ ]
πtCPPI = m ln
Vt (1 − γ)T EP [(GT + φ(V0 − e−rT GT , m)STm )1−γ ]

PO t, St ; m, GT St 1 EP [(φ(V0 , m∗ )STm )1−γ ]
∗
φ(Ṽ0 ,m)
πtOBPI = ln
Vt (1 − γ)T EP [(GT + [φ(Ṽ0 , m)STm − GT ]+ )1−γ ]
0.06 0.06
0.05 0.05
0.04 0.04
Lossrate
Lossrate
0.03 0.03
0.02 0.02
0.01 0.01
0.00 0.00
2.04 4 6 2.04 4 6
m m
Figure 10.2 Loss rates w.r.t. u = uA for CPPI (solid lines), OBPI (dashed) and CM (dotted)
strategies with varying parameter m. The parameters are given in Table 10.2. The investment
horizon is T = 10 years (left graph) and T = 20 years (right graph).
uC = uA and πOBPI is optimal. It holds
lT,A (πCP ) = 0 < lT,A (πOBPI ) < lT,A (πCPPI ).
The utility loss implied by the guarantee is higher for the CPPI than for of the OBPI.
This is illustrated in Fig. 10.2. In addition, notice that the loss rates of the CM strategies
are symmetric in the sense that for > 0, a strategy parameter m = m∗ + implies
the same loss rate as the parameter m = m∗ − . In contrast, OBPI strategies yield
a lower loss rates in the case of m = m∗ + than for m = m∗ − . Intuitively, this
is clear since the protection feature implies that the portfolio weights of the portfolio
insurance strategies are too low compared to the optimal investment proportion m∗ ,
cf. Inequalities (10.19) and (10.28).
For the comparison of CPPI and OBPI, it is important to keep in mind that m∗
is the optimal OBPI parameter for u = uA . In contrast, m∗ is not the optimal CPPI
parameter for u = uA , but for u = uB which includes a subsistence level. In order to
compare the loss rates implied by CPPI and OBPI w.r.t. u = uA , it is thus necessary
to consider the maximization problem

(GT + φ(V0 − e−rT GT , m)STm )1−γ
max EP [uA (VT (π))] = max EP .
π∈CPPI m 1−γ
(10.47)
Figure 10.3 illustrates the loss rates for CPPI and OBPI strategies with varying param-
eter m. In addition, the minimal loss rates are summarized in Table 10.4, i.e., the loss
rates for OBPI strategies with m = m∗ and CPPI for m = m∗∗ , where m∗∗ is the opti-
mal solution for the maximization problem (10.47). Although the OBPI strategy with
parameter m = m∗ is, per construction, the uA -utility maximizing portfolio insurance
0.08 0.08
0.06 0.06
Lossrate
Lossrate
0.04 0.04
0.02 0.02
0.00 0.00
2.04 4 6 8 10 12 14 16 18 1.63 4 6 8 10 12 14 16 18
m m
Figure 10.3 Loss rates implied by CPPI (solid lines) and OBPI (dashed lines) for varying m,
cf. Table 10.3. The risk aversion is γ = 1.2 (left figure) and γ = 1.5 (right figure). The other
parameters are given in Table 10.2.
Table 10.4 Minimal Loss Rates (uA -Optimal Strategy Parameter m)

for Varying T and γ . The Other Parameters are Given in Table 10.2.
Strategy γ\T 1 2 5 10 20
CPPI 1.2 0.040 0.035 0.026 0.018 0.010

(11.32) (7.83) (4.91) (3.57) (2.73)
OBPI 1.2 0.037 0.031 0.022 0.014 0.007
(2.04) (2.04) (2.04) (2.04) (2.04)
CPPI 1.5 0.031 0.026 0.019 0.013 0.007
(10.60) (7.25) (4.45) (3.16) (2.36)
OBPI 1.5 0.028 0.023 0.015 0.009 0.005
(1.63) (1.63) (1.63) (1.63) (1.63)
CPPI 1.8 0.024 0.020 0.014 0.009 0.005
(10.03) (6.80) (4.10) (2.86) (2.08)
OBPI 1.8 0.021 0.017 0.011 0.007 0.003
(1.34) (1.34) (1.34) (1.34) (1.34)
strategy, the additional loss of the CPPI strategy with parameter m = m∗∗ which is
measured by the difference of its loss rate and the one of the OBPI is rather low. Notice
that the differences remain approximatively equal for varying time horizons and risk
aversion parameters.
10.4. UTILITY LOSS CAUSED BY TRADING RESTRICTIONS

AND TRANSACTION COSTS
It is important to notice that in practice the concept of portfolio insurance is impeded by

market frictions. The protection mechanism of portfolio insurance implies that the asset
exposure has to be reduced when the asset price decreases. A sudden drop in the asset
price, where the investor is not able to adjust his portfolio adequately, causes a gap risk,
i.e., the risk that the terminal guarantee is not achieved. One illustrative and meaningful
approach to capture the gap risk is given by the introduction of trading restrictions in the
sense of discrete-time trading and transaction costs. Notice that discrete-time trading
is one possibility to introduce gap risk. In contrast to adding jumps in the dynamics
of the risky asset, it also allows to take into account for transaction costs, which are
of practical importance if one decides whether to use the CPPI or OBPI protection
mechanism. In particular, we consider transaction costs which are proportional to a
change in the position of the risky asset. The proportionality factor is denoted by θ. As
before, we assume that the present value of the terminal guarantee GT prevailing at T
is lower than the initial investment V0 , i.e., V0 > e−rT GT .
Let τ n denote a sequence of equidistant refinements of the interval [0, T ], i.e., τ n =
{t0 = 0 < t1n < · · · < tn−1
n n
< tnn = T }, where tk+1
n
− tkn = T/n for k = 0, . . . , n − 1.
To simplify the notation, we drop the superscript n and denote the set of trading dates
with τ instead of τ n . The restriction that trading is only possible immediately after
tk ∈ τ implies that the number of shares held in the risky asset is constant over the
intervals [ti , ti+1 ] for i = 0, . . . , n − 1. However, the fractions of wealth which are
invested in the risky asset and the zero bond change as underlying prices fluctuate.
Thus, it is necessary to consider the number ϕS of shares held in the risky asset and
the number ϕB of zero bonds with maturity T , i.e., the tupel ϕ = (ϕS , ϕB ).
10.4.1. Discrete-Time CPPI

Along the lines of [3], we consider a discrete-time CPPI version ϕτ = (ϕSτ , ϕBτ ) which
is for t ∈ ]tk , tk+1 ] and k = 0, . . . , n − 1 defined by

mCtτk 1
ϕt,S := max
τ τ
, 0 , ϕt,B := (V τ − ϕt,S
τ
Stk ). (10.48)
Stk Btk tk
Notice that we do not allow for short positions in the risky asset, i.e., the asset exposure
is bounded below by zero. However, similar as for the simple (continuous-time) CPPI,
the discrete-time CPPI does not include short sale restrictions on the riskless asset.
The terminal value of the discrete-time CPPI is given by

min{s,n}
−rT Sti
VTτ = GT + (Vt0 − e GT ) m − K(m) er(T −min{ts ,T }) , (10.49)
i=1
Sti−1
where K(m) := (m − 1)er n /m and ts := min{tk ∈ τ|Vtk < e−r(T −tk ) GT }. We set
T
ts = ∞ if the minimum is not attained. In particular, it holds that ts := min{tk ∈

τ|Stk /Stk−1 < K(m)}. For m > 1, the value of the simple CPPI can drop below the
floor. Therefore, the discrete-time CPPI version introduces a gap risk, i.e., the risk that
the guarantee is violated. For a detailed analysis of the gap risk, we refer to [3].
Besides discrete-time trading, we take also transaction costs into account. Along
the lines of [13], we assume that the transaction costs are financed by a reduction of
the asset exposure arising in the case without transaction costs. This can be justified
by the argument that the protection feature of the CPPI is based on a prespecified
risk-free investment such that the introduction of transaction costs must not change
the number of risk-free bonds, which are prescribed by the CPPI method (without
transaction costs). Thus, the discrete-time CPPI version with transaction costs ϕτ,TA =
(ϕSτ,TA , ϕBτ,TA ) is, for t ∈ ]tk , tk+1 ] and k = 0, . . . , n − 1, defined by
!
mCtτ,TA
k+
1
ϕt,S := max
τ,TA
, 0 , ϕt,Bτ
:= (V τ,TA − ϕt,S
τ,TA
Stk ),
Stk Btk tk+
where Vtτ,TAk+
(Ctτ,TA
k+
:= Vtτ,TA
k+
− e−r(T −tk ) GT ) denotes the portfolio (cushion) value
immediately after tk , i.e., the value net of transaction costs, which are proportional to
the asset price Stk . First, consider the portfolio value Vtτ,TA k
before transaction costs,
i.e., Vtτ,TA
0
:= V t0 and for k = 1, . . . , n
Vtτ,TA
k
:= ϕtτ,TA
k ,S
Stk + ϕtτ,TA
k ,B
Btk
!
mCtτ,TA
= max k−1+
, 0 Stk + (Vtτ,TA
k−1+
− ϕtτ,TA
k ,S
Stk−1 )er(tk −tk−1 )
Stk−1

Stk
= m max{Ctτ,TA
k−1+
, 0} − er(tk −tk−1 ) + Vtτ,TA
k−1+
er(tk −tk−1 ) . (10.50)
Stk−1
Consider now the adjustment to the proportional transaction costs, which are due
immediately after the trading dates. Assuming that the transaction costs are also due
at t0 and that the asset positions are transferred into a cash position immediately after
tn is consistent to the following definitions
Vtτ,TA
0+
:= Vt0 − ϕS,t
τ,TA
0+
θSt0 = Vt0 − mθCtτ,TA
0+
(10.51)
Vtτ,TA
k+
:= Vtτ,TA
k
− |ϕtτ,TA
k+ ,S
− ϕtτ,TA
k ,S
|θStk

St
= Vtτ,TA
k
− mθ max{Ctτ,TA
k+
, 0} − max{Ctτ,TA
k−1+
, 0} k
(10.52)
S tk−1
Vtτ,TA
n+
:= Vtτ,TA
n
− ϕtτ,TA
n ,S
θStn
Stn
= Vtτ,TA
n
− mθ max{Ctτ,TA
n−1+
, 0} . (10.53)
Stn−1
With Eq. (10.51), it immediately follows Ct0 + = Ct0 /(1 + θm). Using Eqs. (10.52)
and (10.50) implies that Ctk + > 0 (k = 0, . . . , n − 1) and θ < 1/m, it holds

Stk+1
Ctk+1 + = Ctk+1
− mθ max{Ctk+1 + , 0} − Ctk + (10.54)
S tk

 1 + θ Stk+1 m − 1 rT St

T

 Ctk + m − e n for er n ≤ k+1

 1 + θm S tk 1 + θm Stk




 1 − θ Stk+1 m − 1 rT
= Ctk + m − e n otherwise

 1 − θm Stk 1 − θm







 S m − 1 rT St
Ctk + (1 − θ)m tk+1 − (m − 1)er n
T
for e n > k+1 .
Stk m(1 − θ) Stk
(10.55)
T
For Ctk + ≤ 0, it follows Ctk+1 + = Ctk+1 = er n Ctk + . It is worth mentioning that the
event {Vtτ,TA
n+
< GT } corresponds to the event that the adjusted cushion drops below
zero during the investment horizon. Notice that for Ctk + > 0

Stk+1 m − 1 rT
{Ctk+1 + < 0} ⇔ < e n =: Ak+1 .
Stk m(1 − θ)
Since the complementary of the event {∪n−1k=0 Ak+1 } is given by the event that all asset
T
price increments are above er n (m − 1)/(m(1 − θ)), it follows with the assumption that
the asset price increments are independent and identically distributed that
n
St1 m − 1 rT
P(Vtτ,TA < GT ) = 1 − P > e n
n+
St0 m(1 − θ)
= 1 − (N (d2TA (θ)))n (10.56)
where
ln (1−θ)m
+ (µ − r) Tn − 21 σ 2 Tn
d2TA (θ) := m−1
. (10.57)
σ Tn
10.4.2. Discrete-Time Option-Based Strategy

According to Eq. (10.26), the (continuous-time) self-financing and duplicating strategy
for the T -payoff GT + φ(Ṽ0 , m)[STm − GT /φ(Ṽ0 , m)]+ is given by

GT
ϕt,S := φ(Ṽ0 , m) PO
t, St ; m, (10.58)
φ(Ṽ0 , m)

φ(Ṽ0 , m)PO t, St ; m, φ(ṼGT,m) − ϕt,S St
ϕt,B := GT + 0
, (10.59)
B(t, T)
where PO is defined as in Eq. (10.27). We consider as a discrete-time version of an
arbitrary continuous-time trading strategy ϕτ = (ϕSτ , ϕBτ ) with respect to the trading
dates τ
ϕtτ := ϕtk for t ∈ ]tk , tk+1 ] and for all t ∈ [0, T ].
Setting V0 (ϕ; τ) := V0 (ϕ), the value process V(ϕ; τ) which is associated with ϕτ is
Vt (ϕ; τ) = ϕtk ,S St + ϕtk ,B e−r(T −t) for t ∈ ]tk , tk+1 ] and 0 ≤ k ≤ n − 1.
In general, the discrete-time version of a continuous-time strategy is not self-financing.

In particular, there are in- or out-flows from the portfolio which occur immediately
after a trading date tk+1 (k = 0, . . . , n − 1). Formally, the costs of discretization
ξtdis
k+1
(ϕ; τ) which occur immediately after the trading date tk+1 are defined by
ξtdis
k+1
(ϕ; τ) := Vtk+1 (ϕ) − Vtk+1 (ϕ; τ) (10.60)
= (ϕtk+1 ,S − ϕtk ,S )Stk+1 + (ϕtk+1 ,B − ϕtk ,B )e−r(T −tk+1 ) .
Notice that negative costs refer to inflows while positive costs imply that further money
is needed to continue the strategy.
Taking proportional transaction costs into account also implies that there are trans-
action costs ξtTA
k+1
(ϕ; τ), which occur immediately after a trading date tk+1 , i.e.,
ξtTA
0
(ϕ; τ) := |ϕt0 ,S |θSt0
ξtTA
k+1
(ϕ; τ) = |ϕtk+1 ,S − ϕtk ,S |θStk+1 for k = 0, . . . , n − 2
and
ξtTA
n
(ϕ; τ) := |ϕtn−1 ,S |θStn .
Defining the payoff V̄T (ϕ; τ) according to the assumption that the inflows into the
strategy are lent according to the interest rate r and outflows are saved according to r
gives

"
n−1
V̄T (ϕ; τ) := Vtn (ϕ) − ξtTA
0
er(T −t0 ) + (ξtdis
k+1
(ϕ; τ) + ξtTA
k+1
(ϕ; τ))er(tn −tk+1 ) .
k=0
(10.61)
10.4.3. Comments on Utility Loss and Shortfall Probability

The loss rates w.r.t. u = uA as well as the shortfall probabilities of the above discrete-
time versions are illustrated in Figs. 10.4 and 10.5. Notice that the introduction of a
0.010
Shortfall probability
0.008
Loss rate
0.006
0.004
0.002
0.000
3 4 5 6 7
m m
Figure 10.4 Loss rates w.r.t. u = uA (shortfall probabilities) implied by continuous-time

CPPI (solid line), monthly CPPI without transaction costs (dashed lines) and monthly CPPI
with θ = 0.01 (dotted line) for varying m. The parameter setup is given in Table 10.2.
0.8
0.10
Shortfall probability
0.08 0.6
Loss rate
0.06
0.4
0.04
0.2
0.02
0.0
0.00
2.03704 4 6 2.04 4 6
m m
Figure 10.5 Loss rates w.r.t. u = uA (shortfall probabilities) in the Merton setup implied
by continuous-time OBPI (solid line), monthly OBPI without transaction costs (dashed lines)
and monthly OBPI with θ = 0.01 (dotted line) for varying m. The parameter setup is given in
Table 10.2.
gap risk, i.e., a strictly positive shortfall probability, gives a loss of minus infinity in the
case of u = uB and u = uC . Observe, that for both strategies, OBPI and CPPI, the loss
which is in the first instance caused by time-discretizing the strategies is rather low.
However, there is a huge impact caused by transaction costs. The effect is even more
pronounced for the OBPI than for the CPPI method. Intuitively, it is clear that in the
limit to continuous-time trading, the transaction costs eat up the cushion, which allows
a risky investment. The convergence of the value (cushion) process of the CPPI is for
example analyzed in [3]. Recall that loss rates above the one of a risk-free investment
are prohibitive. In the case of the basic parameter constellation, this critical value w.r.t.
u = uA is equal to 0.5γ(σm)2 = 0.056. In particular, if the strategy parameter m is
not chosen in a cautious way, portfolio insurance can get prohibitively bad because of
transaction costs.
Consider now the shortfall probability. Recall that, in contrast to the continuous-
time CPPI strategy, the continuous-time OBPI results in a strictly positive probability
that the payoff is not above the terminal guarantee. Thus, it is to be expected that
the shortfall probability of the OBPI is more sensitive to discrete-time trading and
transaction costs than the one of the CPPI, cf. the right graphs presented in Figs. 10.4
and 10.5. This effect is also illustrated in Fig. 10.6, where the distribution function of
the discrete-time versions of OBPI with m = m∗ and CPPI with m = m∗∗ is plotted.
However, to some extend the sensitivity of the OBPI to the gap risk measured by the
shortfall probability is also caused by the dicretization scheme. While the transaction
costs are financed via the cushion for the CPPI, this is not true in the case of the
discrete-time OBPI.
1.0 1.0
Distribution function
Distribution function
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
0.0 0.0
1 2 4 6 8 1 2 4 6 8
Terminal payoff Terminal payoff
Figure 10.6 Distribution functions of terminal values for OBPI (left) and CPPI (right) with
transaction costs (dotted line) and without transaction costs (solid line).
10.5. UTILITY LOSS CAUSED BY GUARANTEES

AND BORROWING CONSTRAINTS
To be practically relevant, it is necessary to take borrowing constraints into account.

Notice that the basic CPPI approach and an OBPI strategy, which is based on syn-
thesizing a power option, can result in arbitrarily high investment weights. Regard-
ing the OBPI, it is not clear how borrowing constraints should be incorporated. One
possibility is given by setting m = 1, i.e., referring to a standard option instead
of a power option. Although this is often done in practice, it will not be con-
sidered in the following. Instead we focus on incorporating borrowing constraints
into the classic CPPI strategy. This straightforwardly results in the capped CPPI,
which we abbreviate with CCP. The capped CPPI strategy ϕCCP = (ϕSCCP , ϕBCCP ) is
defined by
min(ωVtCCP , mCtCCP ) VtCCP − ϕt,S

CCP
St
CCP
ϕt,S = , CCP
ϕt,B = , (10.62)
St Bt
where CtCCP := VtCCP − e−r(T −t) GT and w (w ≥ 1) denotes the restriction on the
investment proportion. In the following, we refer to borrowing constraints in the strict
sense, i.e., we assume that ω is set equal to one.
It is worth mentioning that the borrowing constraints introduce a path-dependence
and the payoff implied by the capped CPPI version cannot be stated as a function of the
terminal asset price as it is the case without borrowing constraints. Intuitively, it is to be
expected that the path dependence yields an additional utility loss in a Black/Scholes
type model setup. In order to calculate the loss rate, we consider the distribution of the
terminal value of the CCP strategy. Let f denote the density function of the terminal
value of the capped CPPI. Then it holds
# ∞
E[uA (πCCP )] = uA (v)f(v)dv
GT
# ∞ 1−γ
1
CE T,A (π CCP
)= v 1−γ
f(v)dv
GT
such that
 
( r+m+ (µ−r)− 21 γ(m∗ σ)2 )T
1  V0 e 
lT,A (πCCP ) = ln  1−γ .
T $∞ 1
v1−γ f(v)dv
GT
For details on the distribution of the capped CPPI, we refer to [4]. Basically, the
distribution can be obtained by considering the process (X)0≤t≤T , which is given by
the dynamics
dXt = (Xt )dt + dWt ,
where
  1 (m − 1)V
 µ−r 1  0

 σ − 2 mσ x≤0 
 σ ln mG mC0 ≥ V0
0
(x) = and X0 = .
µ − r
 1  1
 (m − 1)C0
 − σ x>0  ln mC0 < V0
σ 2 mσ G0
Along the lines of [4], one can show that the value process (VtCCP )0≤t≤T and cushion

process CtCCP 0≤t≤T are, for ω = 1, given by

 m σXt
 e Xt ≥ 0
VtCCP = Gt m − 1 (10.63)
1 + 1 eσmXt

Xt < 0
m−1
and

 m σXt

 m−1 e − 1 Xt ≥ 0
CtCCP = Gt .

 1
 emσXt Xt < 0
m−1
In particular, it holds
 (m−1)v

 1 ln mGt m

 p dv v≥ Gt

 σv σ m−1

  
P[VtCCP ∈ dv] = (m − 1)(v − Gt )

 1  ln 

  Gt  dv m

 p   v< Gt
 σm(v − Gt )
 σm m−1
where p(x) := PX0 (Xt ∈ dx).

The loss rate implied by the capped CPPI is illustrated in Fig. 10.7. Notice that
for m → ∞, the capped CPPI converges to the stop-loss strategy, cf. [13]. Obviously,
the loss rate converges, too. It is interesting to observe that the loss-rate of the capped
CPPI is smaller than the loss-rate of the stop-loss-strategy for m ≥ m∗∗ .
0.08 0.08
0.06 0.06
Loss rate
Loss rate
0.04 0.04
0.02 0.02
0.00 0.00
2.04 4 6 8 10 12 2.04 4 6 8 10 12
m m
Figure 10.7 Loss rates w.r.t. u = uA implied by CPPI (solid lines) and capped CPPI (dashed
lines) for varying m. The risk aversion is γ = 1.2 (left figure) and γ = 1.5 (right figure), the
other parameters are as in Table 10.2. The constant line gives the loss rate of a stop-loss strategy.
10.6. CONCLUSION
The popularity of portfolio insurance strategies including a strictly positive guarantee

component with respect to a fixed investment horizon can be explained by various rea-
sons like regulatory requirements or behavioral finance models. To some extend, the
justification of positive guarantees is also possible assuming that the investor’s prefer-
ences can be described using the von Neumann-Morgenstern framework of expected
utility.
Dating back to Merton, it is well known that in a Black/Scholes model setup
and for a CRRA utility function, the optimal strategy is to invest a constant fraction of
wealth into the risky asset. Such a constant mix strategy implies that, for an investment
proportion m > 1 (m < 1), additional asset are bought (sold) if the asset price
increases. In particular, for m > 1 the resulting payoff is convex in the asset price so that
a constant mix strategy can, at least technically, be classified as a portfolio insurance
strategy. However, the payoff is floored by zero. In theory, it is straightforward to
achieve optimal strategies yielding payoffs with a positive floor. Here, the expected
utility is maximized under the additional constraint that the terminal portfolio value
must be above a strictly positive terminal guarantee. Alternatively, the floor can be
achieved if the utility is measured in terms of the difference of the portfolio value
and the guarantee instead of the portfolio wealth itself, i.e., if a utility function with a
subsistence level is used.
The modified optimization problems help to understand the most prominent
approaches of portfolio insurance strategies, i.e., CPPI and OBPI strategies. The mod-
ifications which are imposed on the unconstrained optimization problem give inter-
esting modifications for the payoffs. Using the unrestricted optimization problem as a
benchmark, the constant mix strategy and its associated payoff with floor zero defines
also a benchmark for OBPI and CPPI strategies. The CPPI results from a subsistence
level, i.e., the utility is measured in terms of the difference of portfolio value and
guarantee instead of the portfolio value itself. In contrast, the OBPI results from the
additional constraint that the terminal payoff is above the guarantee or floor. Consider-
ing the associated payoffs, both approaches result in payoffs which consist of a fraction
of the payoff of the constant mix strategy and an additional term stemming from the
guarantee. Intuitively, it is clear that the fraction is linked to the price of the guarantee,
i.e., the fraction is less than one. The main difference between OBPI and CPPI can
easily be explained by the additional term. In the case of the CPPI approach, the addi-
tional term is simply the guarantee itself, i.e., the payoff of the adequate number of
zero bonds. In contrast, the additional term implied by the OBPI is based on a put on
the fraction of the constant mix payoff with strike equal to the guarantee. Obviously,
the put is cheaper than the zero bond itself. Thus, the OBPI fraction which is held of
the optimal unrestricted payoff is higher than in the case of the CPPI method. This is a
major advantage in terms of the associated utility costs, i.e., the loss in expected utility
which is caused by the introduction of a strictly positive guarantee. The utility costs are
measured and illustrated in terms of a loss rate linking the certainty equivalents of the
strict portfolio insurance strategies to the certainty equivalent of the optimal solution.
One major drawback of the OBPI method is due to its kinked payoff-profile. The
terminal value of the OBPI is equal to the guarantee if the put expires in the money. In
contrast to the CPPI method, this implies a positive point mass that the terminal value is
equal to the guarantee. This relevant probability is given by the real world probability
that the terminal asset prices are below the strike of the put. Intuitively, it is clear that
this can cause a high exposure to gap risk, i.e., the risk that the guarantee is violated, if
market frictions are introduced. We illustrate this effect by taking trading restrictions
and transaction costs into account. It turns out that the guarantee implied by the CPPI
method is relatively robust. However, the probability that the guarantee is not reached
under the corresponding synthetic discrete-time OBPI strategy is rather high.
Finally, we tackle the question of borrowing constraints. In a strict sense, borrow-
ing constraints imply that the proportion of asset must not be above one. In the case
of the CPPI method, the capped CPPI which simply states that the asset proportion is
adequately capped according to the borrowing constraint is of high practical relevance.
We give the distribution of the capped CPPI and illustrate the corresponding loss rate,
i.e., the loss which is due to borrowing constraints.
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11
PORTFOLIO INSURANCES, CPPI AND
CPDO, TRUTH OR ILLUSION?
ELISABETH JOOSSENS∗,‡ and WIM SCHOUTENS†,§

∗
Joint Research Centre of the European Commission
†
Katholieke Universiteit Leuven, Department of Mathematics,
Celestijnenlaan 200B, 3001 Leuven, Belgium
‡
elisabeth.joossens@jrc.it
§
wim@schoutens.be
Constant proportion portfolio insurance (CPPI) and constant proportion debt obligations
(CPDO) strategies have recently created derivative instruments, which try to protect a port-
folio against failure events and have only been adopted in the credit market for the last couple of
years. Since their introduction, CPPI strategies have been popular because they provide protec-
tion while at the same time they offer high yields. CPDOs were only introduced into the market
in 2006 and can be considered as a variation of the CPPI with as main difference the fact that
CPDOs do not provide principal protection. Both CPPI and CPDO strategies take investment
positions in a risk-free bond and a risky portfolio (often one or more credit default swaps). At
each step, the portfolio is rebalanced and the level of risk taken will depend on the distance
between the current value of the portfolio and the necessary amount needed to fulfill all the
future obligations.
We first analyze in detail the dynamics of both investment strategies and afterwards test the
safetyness of both products under a multivariate Lévy setting. More precise we first propose
a quick way to calibrate a multivariate Variance Gamma (VG) process on correlated spreads,
which can then be used to quantify the gap risk for CPPIs and CPDOs.
259
260 Joossens and Schoutens
11.1. INTRODUCTION
Financial institutions try to protect their portfolios against failure events and deriva-
tive instruments are a possible solution. Derivative instruments are a fast-growing
market in which alternative investment strategies such as Constant Proportion Portfo-
lio Insurance (CPPI) and Constant Proportion Debt Obligation (CPDO) are created.
Although these two recently developed instruments function in different ways when
deciding on their investment strategy, both investment funds attempt to provide a
portfolio insurance. More precisely, their strategy is to invest only a part of the cap-
ital in a risky asset and to invest the remainder in a safe way. The total value of
the portfolio at each time step will influence the position taken in the risky asset.
The decisions taken on the risk position at each time step aim to allow the investor
of a CPPI or CPDO to recover, at maturity, a given percentage of their initial cap-
ital, which allows them to benefit from a capital guarantee while participating in
the upside of an underlying asset. It could happen that the promised return is not
achieved. In this case, for the CPPI structure, the bank will have to cover the losses
at maturity while for the CPDO structure, the CPDO will unwind and the investor
will not receive the promised amount at maturity but only the remainder amount at
the time of unwinding. CPPI structures clearly safeguard a given percentage of the
invested capital for the investor, while for CPDO the investor appears to be taking
a risk. In the past, this risk has always been seen as very small and CPDOs have
been sold as very safe. Here, we will study those two products in depth in order to
answer the question whether CPDO and CPPI are really as safe and attractive as they
seem.
First, the concept of credit risk will be introduced. This is the risk that, after
agreeing on a certain contract, one of the involved parties will not fulfil its financial
obligations (such as paying a premium). Often the quality and price of financial prod-
ucts will heavily depend on this risk. Different ways to model this risk are presented and
can be used to price financial products. Next, a credit default swap (CDS) is introduced.
This financial instrument tries to provide a protection for credit risk by transferring it.
In exchange for a predefined cost, also called “spread”, a second party will cover the
losses one might suffer due to credit risk. The costs for such an insurance will clearly
depend on the size of the risk and the impact of the possible losses. Hence, the price
can be determined using the above-mentioned models for credit risk. There are no
obligations to trade credit default swaps so their changes in credit spread can be used
for speculations, for example: CDS spreads can be used as risky assets in investment
structures such as CPPI and CPDO.
The third section will be dedicated to a particular type of insurance portfolio, the
CPPIs. They are a derivative security with capital guarantee using a dynamic trading
strategy in order to incorporate the performance of a certain underlying product such
Portfolio Insurances, CPPI and CPDO, Truth or Illusion? 261
as a simple stock or a CDS. They were introduced more than 10 years ago and are
frequently used.
The investment structure of CPPIs has been and continues to be a popular topic
for research. First, a multivariate jump-driven model, which can be applied for pricing
credit derivatives such as CPDOs, is discussed in detail in Sec. 11.4. Next, in Sec. 11.5,
a more general overview of the other recent developments regarding CPPIs is given.
All papers could be classified under three different fields of interest. A first group
of papers concentrates on proposing different models for pricing. The second group
concentrates on the estimation of the leverage factor in order to fix an upper bound
for the gap-risk, and the third group tries to extend the structure even more in order to
include an extra safety factor.
One of the recent new products based on the idea of a CPPI is the CPDO or
constant proportion debt obligation, which is discussed in Sec. 11.6. CPDOs are used
for credit portfolios comprising exposures to credit indices such as iTraxx and CDX.
The CPDO structure borrows many features from the CPPI structure, such as the
constant proportion. The main goal of a CPDO is to produce a high-yielding product
and this is achieved through a high degree of leverage. Contrary to a CPPI investment
strategy, leverage will be increased when the net asset value of the portfolio decreases
and descends below the target amount, but leverage will be decreased when the net
asset value of the portfolio increases and approaches the target. Once a CPDO reaches
this target amount, it will completely de-leverage. In this section, we will not only
focus on the dynamics of the structure but we will also give a short overview of the
research concentrating on this topic and discuss the question of the “safeness” of this
structure as has been highlighted recently in the news.
We will conclude by discussing in more depth the differences and similarities of
CPPI and CPDO. This should give an even better insight into the structure of both
financial instruments.
11.2. CREDIT RISK AND CREDIT DEFAULT SWAPS
This section is intended to give a short introduction to the main financial concepts,
which will play a role in this work. First, the concept of credit risk is introduced and
different ways to model this risk are discussed. Next, a short introduction on credit
derivatives, i.e., more precise credit default swaps, is provided.
11.2.1. Credit Risk

Credit risk refers to the risk that a specified reference identity does not meet its credit
obligations within a specified time horizon T (called maturity). In other words, when-
ever two or more parties sign an agreement, there is a risk that one of them will not
meet its obligations. A simple example is the case, where a single person signs a loan
with a bank. Here, it can happen that the person does not repay his debt according to
the agreement. In such a case, we say that default will have occurred. The risk that
such an event will happen is called credit risk and will always be spread over a certain
time length.
Taking a more global perspective, in finance we do not only deal with the situation
of a person and a loan but it will always be possible to characterize the credit risk in
terms of the following components: the obligor, the set of criteria defining the default,
and a time interval over which the risk is spread. When, for instance, we talk about
bonds, their default can be defined in several ways. It could, for example, be bankruptcy
but it might also be a rating downgrade of the company or failure to pay an obligation
(such as a coupon). But it could also concern the value of a firm — here a firm’s
value is linked to the value of its financial assets. In general one will look at the firm’s
asset value V = Vt , 0 ≤ t ≤ T and default will be defined as a boundary condition
on the asset value. For example a default event will occur if the value falls below a
certain fixed level L within the time horizon. Figure 11.1 presents two possible paths
250
200
150
t
V
100
50
0
0 1 2 3 4 5 6 7 8 9 10
τ T
Figure 11.1 Two possible paths for a firm’s asset value over time with T = 10. When the
black line occurs the obligor will default (when Vt < L) in the gray case the obligor will
survive.
for the firm value over time [0, 10] modeled through Black–Scholes, where µ = 0.05,
σ = 0.4, and S0 = 100 as explained below. In the case of the black line, the value of
the firm will fall below the lower bound, which is fixed at 20 just before t = 5 and
hence will default. In the case that the firm value follows the gray path, no default will
occur before T = 10.
As one will try to protect oneself from defaults, the size of credit risk will be
one of the crucial factors when determining the prices and hence the techniques for
estimating the probability of default of a reference entity within time T will be very
important.
Developing new models for the estimation of credit risk is an important topic in
the field of finance. The strong interest in this topic is also linked to the fact that in the
last couple of years the volume of instruments linked to credit risk traded on the market
has increased exponentially. Besides the increase in investments, there has also been
interest due to the Basel II Accord, which encourages financial institutions to develop
methods for assessing their risk exposure. Credit risk models are usually classified into
two categories: reduced-form models, including intensity-based models, and structural
models.
Intensity-based models, also known as hazard-rate models, focus directly on mod-
eling the default probability. The main idea of these models lies in the fact that at any
moment in time (as long as the contract is running) there is a probability that an obligor
might default. Default is defined at the first jump of a counting process with a certain
intensity. In practice, the models assume that the intensities of the default times follow
a certain process (stochastic or deterministic) and under those conditions the under-
lying default model can be constructed. This intensity of the process depends heavily
on the firm’s overall health and on the situation of the market.
The structural models, also known as firm-value models, link default events to the
value of the financial assets of the firm, such as in the example presented above. Credit
risk will hence depend on the model used for the value of the financial assets of the
firm and the criteria used for a default. This approach will almost always be used in
the remainder of this chapter when modeling the credit default.
A common way to model the time evolution of assets uses the following diffusion
process:
dSt = St (µdt + σdWt ), S0 > 0, (11.1)
where Wt is a standard Brownian motion. Here, µ and σ > 0 are the so-called drift
and volatility factors.
The path of a Brownian motion is continuous and can easily be simulated when
one discretizes the time using very small steps t. The value of a Brownian motion
at time {nt, n = 1, 2, . . .} is obtained by sampling a series of independent standard
normal random numbers {νn , n = 1, 2, . . .} and setting:

√
W0 = 0 and Wnt = W(n−1)t + tνt .
The solution of the SDE given in Eq. (11.1) is called geometric Brownian motion and
is given by
St = S0 exp((µ − σ 2 /2)t + σWt ). (11.2)
The above way to model price changes of financial products is also referred to as
the Black–Scholes model. The main advantages of using the Black–Scholes model is
that it is easy to understand. Calculation of prices of derivatives under the model is
moreover typically not that time-consuming. A drawback is that it assumes normality
of the log returns of the financial assets, which is often not true in reality. Moreover,
the Black–Scholes model does not capture the possibility of sudden jumps, which do
occur in real live and often cause extra credit risk. Hence, a more flexible stochastic
process is often required to model reality in a better way.
It would be good to keep some properties of the Brownian motion such as inde-
pendence and stationarity of the increments but to drop the constraints of normality
and continuity of the paths. To create such a process, we must restrict ourselves to
the group of infinitely divisible distributions. For each infinitely divisible distribution
(with characteristic function φ(u)), a stochastic process can be defined which starts
at zero and has independent and stationary increments such that the distribution of
the increments over [s, s + t], s, t ≥ 0 has (φ(u))t as characteristic function. Such
processes are called Lévy processes, in honour of Paul Lévy, a pioneer of the theory.
Definition 11.1. Lévy process: A cadlag stochastic process X = {Xt , t ≥ 0} defined

on a probability space (, F, P) is a Lévy process if the following conditions hold:
(1) Xt is a continuous process P-almost surely:
∀ε > 0 : lim P(|Xt+h − Xt | ≥ ε) = 0.

h→0
(2) X0 = 0.
(3) The process has stationary increments.
(4) The process has independent increments.
Lévy process became very popular and are still more and more used in practice.
Examples of Lévy process are the (compound) Poisson process, the Gamma process,
the inverse Gaussian process, and the Variance Gamma process (VG). An in-depth
study of Lévy process in finance and how they can be applied can be found in [1].
Next, we will define an important group of credit derivatives, which are often used
in practice.
11.2.2. Credit Default Swaps (CDS)

Credit Default Swaps (CDSs) are very simple credit derivatives and have a big share
in the market of credit derivatives. Credit derivatives can be defined as the group of all
derivatives, whose payoffs are affected by the default of a specified reference entity (or
a basket of entities). They are often used to hedge, transfer, or manage the risk and can
hence be considered as an insurance against default. The main idea of credit derivatives
is that credit risk is transferred without reallocating the ownership of the underlying
asset(s). This way they provide a certain protection against decreasing solvency or
default of the underlying asset(s).
CDSs in particular are designed to isolate the risk of default on a credit obligation.
A CDS is a bilateral agreement, where the protection buyer transfers the credit risk of a
reference entity to the protection seller for a determined amount of time T . In exchange
for this shift of risk, the protection buyer will make predetermined payments to the
protection seller. These payments will occur until the end of the contract (the time of
maturity) T unless a default event occurs before the time to maturity. If default of the
reference entity occurs, the protection seller will cover the losses (or part of the losses)
of the protection buyer due to the default of the underlying entity and the contract will
be terminated. The yearly rate paid by the protection buyer to enter a CDS contract
against failure is called the CDS spread. Spreads are almost always quantified in bp
where bp stands for “basis point” and is equal to 0.01%. The amount of the spread
will reflect the riskiness of the underlying credit, if the probability of default increases
also the cost of the CDS (and hence the spread) will increase. We note that CDSs are
often also used to speculate on changes in credit spread.
Figure 11.2 presents the cash flows for two possible scenarios (default at time
t = 7 or no default) for an example. We consider the case where a person owns a
zero-coupon defaultable bond of a company with a face value F = 10,000 Euro
and maturity T = 10 years. Suppose that this person would like to cover himself
against the possible default of the bond. He can buy this protection by entering into
a CDS contract. A possible situation would be that the contract requests an annual
payment of an amount of 400 bp from the protection buyer to be protected against
the default. In return, the protection seller will cover the loss, which might result
from defaulting. The amount of the loss will be equal to the difference between F
and the recovery value after default. We hence take into account that when a default
event occurs, the total amount will not automatically be lost completely, but part of
the value might be recovered. The concept of recovery can be understood through
the following example. In the case that a company goes bankrupt, there are creditors
claiming against the assets of the company, and the owner of the bond is one of those
creditors. The assets are sold by a liquidator and the profits are used to meet the
claims as far as possible. Historically values of the recovery rate fall between 20%
7000
6000
5000
4000
Euro
3000
2000
1000
1000
1 2 3 4 5 6 7 8 9 10
Year
Figure 11.2 Cash flows from the protection buyer for a 10-year CDS. Black: cash flows in
case no default occurs. Gray: cash flows in case there is a default at time t = 7.
and 50%. For the current example, we assume that the recovery rate will be equal to
R = 40%.
The annual amount paid by the protection buyer in this example is hence equal to
400 bp · 10,000 = 400 Euro and the payment of the protection seller in case of default
will be F(1 − R) = 6000 Euro. In Fig. 11.2, it is assumed that in the second scenario
the bond defaulted at the beginning of the seventh year.
Pricing models for CDSs based on Lévy processes can be found in [2] and [3].
In practice, CDS are not only used to reallocate the risk of a single asset (the
so-called single name CDS), but also a basket of assets might be considered. A credit
default swap index is a credit derivative used to hedge credit risk or to take a position on
a basket of credit entities. There are currently two main families of CDS indices: CDX
and iTraxx. CDX indices contain North American and Emerging Market companies,
whereas iTraxx contains companies from the rest of the world.
One of the most widely traded index is the iTraxx Europe index composed of the
most liquid 125 CDS referencing European investment grade credits. There are also
significant volumes, in nominal values, of trading in the HiVol index. HiVol is a subset
of the main index consisting of what are seen as the most risky 30 constituents at the
time the index is constructed. Typically every six months new series of CDS indices
are issued.
Indices are like CDSs not only used as insurance against default risk but are also
traded on the market in a speculative way.
11.3. PORTFOLIO INSURANCES
Portfolio Insurances are capital guarantee derivative securities that embed a dynamic
trading strategy in order to make a contribution to the performance of a certain under-
lying product (e.g., an asset, a CDS or a CDS index, …).
One particular type is considered here, the constant proportion portfolio insurance
e.g., [4], investing partially in a risk-free way and combining this with a risky asset.
The family of Constant Proportion Portfolio Insurance consists of investments
for which the amount necessary for guaranteeing a repayment of a fixed amount N at
maturity T is invested in a risk-free way, typically a bond, B, and only the exceeding
amount will be invested in one or more risky assets, S (i) . This way an investor can limit
its downside risks and maintain some upside potential. This type of portfolio insurance
has first been introduced by [5] and [6].
The product manager will take larger risks when his strategy performed well. But
if the market went against him, he will reduce the risk rapidly. The following factors
play a key role in the risk strategies an investor will take:
• Price: The current value of the CPPI. The value at time t ∈ [0, T ] will be denoted
as Vt .
• Floor: The reference level to which the CPPI is compared. This level will guarantee
the possibility of repaying the fixed amount N at maturity T , hence it could be seen
as the present value of N at maturity. Typically this is a zero-coupon bond and its
price at time t will be denoted as Bt .
• Cushion: The cushion is defined as the difference between the price and the floor:
Cushion = Price − Floor.

• Cushion%: It is defined as the ratio of the cushion over the price.
• Multiplier: The multiplier is a fixed value, which represents the amount of leverage
an investor is willing to take.
• Investment level: It is the percentage invested in the risky asset portfolio; this also
known as the exposure and is for each step fixed at:
e = Multiplier × Cushion%.
• “gap” risk: This is the probability that the CPPI value will fall under the floor.
The level of risk an investor will take at each time t is equal to the investment level as
long as the value of the CPPI exceeds the floor. For any time t, the future investment
decision will be made according to the following rule:
• If Vt ≤ Floor = Bt , we will invest the complete portfolio into the zero-coupon
bond.
• If Vt > Floor, we will invest a proportion equal to e in the risky asset portfolio.
It can easily be shown that under the assumption that the underlying asset price follows
a Black–Scholes model with continuous trading, there is no risk of going below the
floor and that the expected return at maturity of the CPPI is equal to [7]
E[VT ] = N + (V0 − Ne−rT ) exp(rT + m(µ − r)T ).
In practice, however, it is known that the probability of going below the floor is non-
zero. It might, for instance, happen that during a sudden downside move or due to
overnight changes, the fund manager might not be able to adjust the portfolio in time.
In the case of an event where the actual portfolio value falls under the floor, at maturity
the issuer will have to cover the difference between the actual portfolio value and the
guaranteed amount N. It is therefore of importance for the issuer of a CPPI note to be
able to quantify this risk, also called gap risk.
We will present an example of a possible cash flow for a CPPI with maturity T
equal to 10 years. For the sake of simplicity, we will consider only one underlying
asset with prices St and a risk-free asset, a zero-coupon bond Bt with a constant interest
rate r = 5%. We also assume that the initial price of the asset is equal to S0 = 100
and the prices over time are simulated from a Variance Gamma model, which will be
presented later (see Eq. (11.4)) with parameters σ = 0.5, ν = 0.25, and θ = 0.026.
For the CPPI process, the leverage or multiplier is fixed at 2.5 and the starting capital
is 100. We also consider that the CPPI at maturity repays the investor with at least the
initial capital. Figure 11.3 presents two examples of possible scenarios for the simple
CPPI. In the example on the left, the value of the CPPI will always stay above the floor,
while in the second example (on the right) at time τ a sudden drop of the risky asset
will result in a CPPI value below the floor, which is the gap risk. Note that different
scales are applied for the presentation of the results.
In this example, as the repayment at maturity of the initial value should be insured,
the floor will be 100 exp(−r(10 − t)) at each time t. For each step, the value of the
cushion is calculated and the portfolio is re-balanced according to the risk exposure.
The re-balancing is such that the bigger the difference between the CPPI value and the
floor, the higher the cushion value and the more risk one will take. The process will
stop at maturity or once a drop of the asset value occurs of such a level that the CPPI
value falls below or hits the floor. If such a drop happens the product manager will put
the risk exposure to zero and only invest in a risk-free way until maturity.
May 12, 2010
Portfolio Insurances, CPPI and CPDO, Truth or Illusion?
17:47
CPPI value stays above floor CPPI value drops bellow floor
300 300
WSPC/SPI-B913
Stockvalue
200 200
Value
Value
100 100
Stockvalue
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
120 200
CPPI
Bondfloor
100 150
Value
Value
80 100
CPPI
Bondfloor
60 50
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
60
Cushion 100 Cushion
40
Value
Value
50
b913-ch11
20
0
0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Time Time
Figure 11.3 Value of the risky asset (top), CPPI performance (central), and cushion (bottom) in case the CPPI value stays above the floor (left)
FA
and in case a sudden downwards jump occurs and the CPPI value drops bellow below the floor (right).
269
Recent papers discuss different aspects of this group of investment strategies. In

the next section, an overview of the main findings is given.
11.4. MODELING OF CPPI DYNAMICS USING MULTIVARIATE

JUMP-DRIVEN PROCESSES
This section is based on [8] and presents a possible way of modeling credit CPPI
structures. More precise, a dynamic Lévy model (VG) is set up for a series of correlated
spreads.
A recent innovation is the possibility to trade swaptions, an option granting its
owner the right but not the obligation to enter into an underlying swap (e.g., a CDS),
on indices. We will make use of these instruments to calibrate the underlying dynamic
spread models. The parameters of the model actually come from a two-step calibra-
tion procedure. First, a joint calibration of the correlated spreads on swaptions and
second by a correlation matching procedure. For the joint calibration, we make use of
equity-like pricing formulas for payers and receivers swaptions based on characteristic
functions and Fast Fourier Transform methods. To obtain the required correlation, we
set by a closed-form matching procedure the models correlation exactly equal to a
prescribed (e.g., historical) correlation. We then have a model in place that can gener-
ate very fast correlated spread dynamics under jump dynamics. The calibrated model
can be used to price a whole range of exotic structures. We illustrate this by pricing
credit CPPI structures. The CPPI structures considered in this section are such that the
invested capital is put in a risk-free bond and a position is taken on credit derivatives
indices (usually protection is sold). As discussed before, important in the handling of
CPPIs is assessing the risk that spreads of the underlying credit indices jump and lead
to so-called gap risk. Because of the built in jump dynamics, a better assessment of
this gap risk is made possible.
11.4.1. Multivariate Variance Gamma Modeling

Next, a dynamic Lévy model, more precise a Multivariate Variance Gamma (MVG)
model, is set up for a series of correlated spreads. As this model can generate correlated
spreads in fast way, it can be applied in order to price different exotic structures such
as the CPPI.
For the construction of the Multivariate Variance Gamma model, the authors start
from the Univariate Variance Gamma process. The Variance Gamma process was
introduced in the financial literature by [9]. The characteristic function of the Variance
Gamma (VG(σ, ν, θ)) distribution is defined as follows:

1 2 2 −1/ν
φVG (u; σ, ν, θ) = 1 − iuθν + σ νu .
2
The distribution is known to be infinitely divisible and by standard Lévy theory one
thus can build out of such a distribution a process. The VG process is defined as
X(VG) = {Xt(VG) , t ≥ 0} with parameters σ, ν > 0, and θ. It is a process, which
starts at zero has stationary and independent increments, and for which the increments
(VG) √
Xs+t − Xs(VG) follow a VG(σ t, ν/t, tθ) distribution over the time [s, t + s] (for more
details see [1]). Theoretical background on Lévy process can be found in [10] and [11].
For some historical background on the VG model see [12].
Another way of constructing the VG process is by the technique of time chang-
ing. Here, we will start from a Gamma process. Recall that the density function of a
Gamma(a, b) distribution is given by
ba a−1
fGamma (x; a, b) = x exp(−xb), x > 0, and a, b > 0,
(a)
where (.) is the Gamma function. It is known that the distribution is infinitely divisible
and hence using the Gamma distribution one can build a process with independent and
stationary Gamma increments. Defining G = {Gt , t ≥ 0} as a Gamma process with
parameters a = b = 1/ν, the resulting Gt will follow a Gamma(at, b) distribution and
E[Gt ] = t. A VG process can be constructed by time-changing a Brownian Motion
with drift. More precisely, one can show (for more details see [1]) that the process
Xt(VG) = θGt + σWGt , t ≥ 0, (11.3)
where W = {Wt , t ≥ 0} is a standard Brownian motion independent from the Gamma
process, is indeed a VG process with parameters (σ, ν, θ).
The construction can be interpreted as if we now look at a Black–Scholes world
but now measured according to a new business clock (Gamma time). It has proven to
be very successful in the univariate setting, as the underlying VG distribution can take
into account, in contrast to the Normal distribution, skewness, and excess-kurtosis.
In [13], a VG model was used to accurately fit CDS curves.
With this alternative definition, we have an easy way to simulate a sample path
of the VG processes, which can be obtained by sampling a standard Brownian motion
and a Gamma process. The Gamma process can easily, like the Brownian motion, be
simulated at time points {nt, n = 1, 2, . . .} with t small. First generate independent
Gamma(at, b) random numbers {gn , n = 1, 2, . . .}. Then, the Gamma process can
be constructed by
G0 = 0 and Gnt = G(n−1)t + gn , n ≥ 1.
Similarly to Eq. (11.2) for the Brownian motion, the value over time of an asset using
the dynamics of a Variance Gamma process can now be modeled by
St = S0 exp(ωt + θGt + σWGt ), (11.4)
with ω = ν−1 log(1 − σ 2 ν/2 − θν).
We work with multivariate extensions of the model along the technique described
in [14] and [15]. Additionally, we want to note that in [9], a symmetric version of a
multivariate VG is initiated.
To build the multivariate VG process a Gamma process G = {Gt , t ≥ 0} is needed,
where the parameters a and b are both fixed at 1/ν. Also an N-dimensional Brownian
motion is introduced W = {W t , t ≥ 0}, where W t = (Wt(1) , Wt(2) , . . . , Wt(N) ). It is
assumed that this process is independent of the Gamma process and that the Brownian
motions have a correlation matrix given by ρW = (ρijW , i, j, = 1, . . . , N)
(i) (j)
ρijW = E[W1 , W1 ].
A multivariate VG process X = {X t = (Xt(1) , . . . , Xt(N) ), t ≥ 0} is defined as

Xt(i) = θi Gt + σi WG(i)t .
Note that there is dependence between the Xt(i) ’s due to two causes: they are all con-
structed by a time change with a common Gamma time. This will mean that the
processes will all jump together, but jumps’ sizes can be different. Moreover, there
is dependency also built in via the Brownian motions. A straightforward calculation
shows that the correlation between two components is given by
(j) (j)
E[X1(i) X1 ] − E[X1(i) ]E[X1 ] θi θj ν + σi σj ρijW
ρij = = . (11.5)
(j)
Var[X1(i) ] Var[X1 ] σi2 + θi2 ν σj2 + θj2 ν
This clearly shows that, even if we assume the Brownian components to be independent
of each other, one still obtains a correlation between the different components because
of the common gamma time.
Suppose that we need to model, as later on will be the case, the evolution of N-
correlated spreads. Take for example the evolution of the iTraxx Europe main index
and its overseas opponent the Dow Jones CDX.NA.IG main index and/or the spreads
of their HiVol subsets.
We assume the following correlated dynamics for the evolution of N-dependent
spreads:
St(i) = S0(i) exp(ωi t + θi Gt + σi WG(i)t ) = S0(i) exp(ωi t + Xt(i) ), i = 1, . . . , N,
where

1
ωi = ν−1 log 1 − σi2 ν − θi ν .
2
These mean-correction terms, ωi , are in place because one can then easily show that
the spread processes are mean-reverting in the sense that we have for every t ≥ 0
E[St(i) ] = S0(i) .
11.4.2. Swaptions on Credit Indices

The two most liquidly traded index swaptions types are payers and receivers. These
are typically European style. A payer/receiver option holder has on expiry the right
but not the obligation to buy/sell protection on the underlying index at the strike level.
If a default happens among the index constituents prior to option expiration, both the
buyer of a payer or the seller of a receiver option can trigger on expiry a credit event
(so-called non-knockout feature).
The payoff of an index swaption at expiry has two components: payoff due to
difference between expiry spread level and the strike and payoff due to any default
losses. For short-maturity options, the later is very unlikely to happen and is often
ignored.
Let us introduce some notation. Denote by T the (payer or receiver) swaption
maturity (typical 3, 6, or 9 months) and by T ∗ the index maturity (typically 5, 7, or 10
years). Let us denote with At the risky annuity for maturity t (i.e., the present value
of 1 bp of the fee leg). The forward annuity is denoted by A(T, T ∗ ) and is the forward
annuity from swaption maturity to index maturity as of the trade day (t = 0). We have
of course that At = A(0, t) and A(T, T ∗ ) = AT ∗ − AT .
The forward spread as of the trade day (i.e., at time t = 0) with 0 ≤ T < T ∗ ,
F0 = F0 (T, T ∗ ) is the forward spread from swaption maturity T to index maturity T ∗
and is given by
St At − Ss As
F0 (s, t) = .
At − A s
11.4.2.1. Black’s model

The market standard for modeling credit spreads options is a modification of the Black’s
formula for interest rate swaptions (see ( [16])). It models spread dynamics in the same
way as in Eq. (11.2), where µ = 0.
Black’s formula for the value of a payer/receiver swaption with maturity T and
strike value K is given by
Payer(T, K) = A(T, T ∗ )(F0 N(d1 ) − KN(d2 )),
Receiver(T, K) = A(T, T ∗ )(KN(−d2 ) − F0 N(−d1 )),
where
log(F0 /K) + σ 2 T/2 √
d1 = √ and d2 = d1 − σ T .
σ T
If the payer swaption is non-knockout, as is typically the case for the index swaptions
we are dealing with, we adjust the forward spread to account for the non-knockout
feature of index options. We account for this additional protection by increasing the
forward spread by the cost of this protection. More precisely, the adjusted forward
spread is given by
S T ∗ AT
(T, T ∗ ) = F0 (T, T ∗ ) +
(adj) (adj)
F0 = F0 ,
AT ∗ − A T
and the price of non-knockout payers and receivers are respectively given by
Payer(T, K) = A(T, T ∗ )(F0

(adj)
N(d1 ) − KN(d2 )),
Receiver(T, K) = A(T, T ∗ )(KN(−d2 ) − F0
(adj)
N(−d1 )),
where
log(F0
(adj)
/K) + σ 2 T/2 √
d1 = √ and d2 = d1 − σ T .
σ T
Summarizing, we want to remark on the striking connection with vanilla option prices
in equity. Basically, pricing comes down to pricing under a Black–Scholes regime with
no interest rates and no dividends. However, the model has all the deficiencies of the
Black–Scholes framework: no-jumps, light-tails, symmetric underlying distribution,
etcetera.
11.4.2.2. The variance gamma model

Completely similar to the equity setting. The Black–Scholes dynamics are replaced
with the better performing jump dynamics of a Variance Gamma process. We now
model the spread dynamics as
St = S0 exp(ωt + θGt + σWt ) = S0 exp(ωt + Xt ).
Pricing of vanillas has already been worked out in full detail in equity settings by [17]
and by a slight adaption to the credit setting we can very fast calculate payer and
receiver swaptions using the Carr–Madan formula in combination with fast Fourier
transform methods. More precisely,
exp(−α log(K))
Payer(T, K) = A(T, T ∗ )
π
+∞
φ(v − (α + 1)i; T )
× exp(−iv log(K)) dv,
0 α2 + α − v2 + i(2α + 1)v
where the characteristic function of the log of the adjusted forward spread process at
maturity T is given by
(adj)
φ(u; T ) = E[exp(iu(log F0 + ωT + XT ))],
which is known analytically in many Lévy settings, including VG.

11.4.3. Spread Modeling by Correlated VG Processes

We now have a multivariate spread model available, and a fast pricers for the standard
payer and receiver swaptions. Using these fast pricers on these index swaption, one
can calibrate the model in a two steps procedure.
(1) We will make sure that our model reproduces the swaption market data as best as
possible by doing a joint calibration using our fast FFT pricer. This step will give
parameter estimators for the σi , ν, and θi .
(2) We put in place the exact correlation structure we want, by calculating (using
a closed-form formula) the correlation matrix of the underlying driving standard
Brownian motions. Note, that the matrix calculated in the this fashion is not neces-
sary positive-definite. In such a situation, one can then as a kind of ad hoc method
look for the closed positive-definite matrix and work with that one.
The model is illustrated by a worked out example, where we price a CPPI structure.
11.4.3.1. The pricing of CPPIs

We work out the details of credit CPPI by an example, where positions will be taken
in four highly correlated indexes and a predefined trading strategy is in place.
In our example, we take positions in the following index products:
• iTraxx Europe Main on the run (5 years) unfunded
• iTraxx Europe HiVol on the run (5 years) unfunded
• DJ CDX.NA.IG Main on the run (5 years) unfunded
• DJ CDX.NA.IG HiVol on the run (5 years) unfunded
The swap rates for the above products are highly correlated as can be seen from
Fig. 11.4.
The corresponding correlation matrix of spreads itself and the correlation matrix
of the corresponding daily log returns based on observations from the 21st June 2004
until 13th March 2007 are given in Tables 11.1 and 11.2, respectively.
We start with a portfolio of say 100M EUR and an investment horizon of six
years. We want to have the principal of the initial investment protected. Therefore,
we calculate the bond floor as the value of a risk-free bond that matures at the end
of the investment horizon. Suppose we take r = 0.04 and use compound interest
rates, then the bond-floor is initially at 78.6628M EUR. Suppose we set the leverage
at m = 30. Initially, the cushion is thus at 21.3372M EUR. Multiplying the cushion
with the constant leverage factor of 30 gives the risky exposure that we are going to
take, namely, 640.12M EUR. We are taking the following positions:
• Sell protection on iTraxx Europe Main on the run (5 years) for half of the risky
exposure.
Evolution of Main and HiVol indices : iTraxx and CDX.IG

180
iTraxx Main
iTraxx HiVol
160
CDX Main
CDX HiVol
140
120
Spread
100
80
60
40
20
Jan-04 Time Mar-07
Figure 11.4 Evolution of Main and HiVol indices: iTraxx and CDX.IG.
Table 11.1 Correlation of Spreads: iTraxx (Main and HiVol) and CDX
(Main and HiVol).
Correlation iTtraxx Main iTraxx HiVol CDX Main CDX HiVol
iTtraxx Main 1.0000 0.9162 0.9194 0.8469

iTraxx HiVol 0.9162 1.0000 0.7687 0.7580
CDX Main 0.9194 0.7687 1.0000 0.9446
CDX HiVol 0.8469 0.7580 0.9446 1.0000
Table 11.2 Correlation of Log-Returns: iTraxx (Main and HiVol) and

CDX (Main and HiVol).
Correlation iTtraxx Main iTraxx HiVol CDX Main CDX HiVol
iTtraxx Main 1.0000 0.9258 0.4719 0.3339

iTraxx HiVol 0.9258 1.0000 0.4398 0.3281
CDX Main 0.4719 0.4398 1.0000 0.8580
CDX HiVol 0.3339 0.3281 0.8580 1.0000
• Buy protection on iTraxx Europe HiVol on the run (5 years) for 12 125
30
of the risky
exposure.
• Sell protection on DJ CDX.NA.IG Main On the run (5 years) for half of the risky
exposure.
• Buy protection on DJ CDX.NA.IG HiVol On the run (5 years) for 12 125
30
of the risky
exposure.
The risky exposure is actually taken in position in iTraxx Europe Main and DJ
CDX.NA.IG Main. By buying some protection on their HiVol components, the actual
risky exposure is reduced and one is only exposed to the non-HiVol names in both
indices. This is often done to eliminate as much as possible default risk. If a name
defaults, it will most likely be a HiVol name.
The initial 100M EUR are put on a risk-free bank account at a compound rate of
four percent.
Suppose the current quotes for the four components of our portfolio are these as
given in Table 11.3.
We rebalance after regular times, say daily and continue doing this until maturity
or until we have a negative cushion at a rebalancing date. In that case, all positions are
closed. We can however not pay back the principal amount since the portfolio value
is below the bond-floor. This is called gap risk (see Fig. 11.5). One of the aims of the
model is to calculate the gap risk or in other words the present value of these gaps.
We assume the following correlated VG dynamics for the spreads:
St(1) = S0(iTraxxMain) exp(ω1 t + θ1 Gt + σ1 WG(1)t )
St(2) = S0(iTraxxHiVol) exp(ω2 t + θ2 Gt + σ2 WG(2)t )
St(3) = S0(CDXMain) exp(ω3 t + θ3 Gt + σ3 WG(3)t )
St(4) = S0(CDXHiVol) exp(ω4 t + θ4 Gt + σ4 WG(4)t ),
where Gt is a common Gamma Process such that Gt ∼ Gamma(t/ν, 1/ν) and Wt(i) are
correlated standard Brownian motions with a given correlation matrix ρW = (ρijW ).
Table 11.3 Current Quotes for the Four

Components of Our Portfolio in bp.
t=0
iTtraxx Main 24.625

iTraxx HiVol 48.75
CDX Main 37.5
CDX HiVol 88.5
CPPI
105
Deleverage Bond floor
Portfolio
100
95
Value
90
Gap risk
85 Leverage
80
75
0 1 2 3 4 5 6
Time
CPPI  Risky exposure

600
Risky exposure
500 Deleverage
400
300
200
100
Leverage
0
0 1 2 3 4 5 6
Time
Figure 11.5 CPPI performance, leveraging, deleveraging, and gap risk in a multivariate VG
driven model.
The log-returns in this model have a correlation structure as in Eq. (11.5).

We will first perform a joint calibration on swaptions of the individual indices. This
determines the parameters ν, θi , and σi , i = 1, . . . , 4. Next, we match the historical
correlations with ρij by setting

ρij σi2 + θi2 ν σj2 + θj2 ν − θi θj ν
ρijW = .
σi σj
Hence, we are able to match quite accurately all the individual spread dynamics by
correlated jump processes and moreover are able to impose a correlation structure
completely matching the observed historical correlation. Indeed for our example, the
result of the calibration can be found in Fig. 11.6. In order to match with the required
correlation, which we have taken from the log-return historical correlation from 21
June 2004–13 March 2007 as shown in Table 11.2, we need to set the Brownian
correlation matrix equal to
 
1.0000 0.9265 0.4935 0.3352
0.9265 1.0000 0.4470 0.3247
ρW =  0.4935 0.4470 1.0000 0.8688 .

0.3352 0.3247 0.8688 1.0000
In Fig. 11.7, one sees a typical picture of the correlated moves under the multivariate
VG jump dynamics.
11.4.3.2. Gap risk

As already mentioned in the previous section, the gap risk under Black’s model under
continuous rebalancing is zero. Of course, because the continuous paths of the Brown-
ian Motion, the bond floor is never crossed but at maximum hit. One could artificially
rebalance only periodically, say quarterly, in order to generate some gap risk. Much
more natural and conform reality is to rebalance continuously (or daily), but to include
jump dynamics in the model. Indeed, if jumps are present in the spread dynamics,
then the portfolio value can suddenly jump below the bond-floor. Hence, the price of
this gap risk is not zero anymore. The price to cover against the gap risk, estimated
on 100,000 Monte Carlo simulations of the multivariate VG model in our example for
instance is around 5 bp per year.
Finally, we want to note that the model is not restricted to a credit setting, but one
can pimp the model to a hybrid setting. One can set up multivariateVG dynamics, where
for example equity indices and stock dynamics are combined with credit dynamics.
This is possible in case fast vanilla pricers are available under a univariate VG model,
like is the case for equity vanillas and credit swaptions.
Calibration on swaptions.
Figure 11.6
Correlated VC spread paths

120
iTraxx Europe
iTraxx Hivol
CDX IG
CDX Hivol
100
80
Spreads (bp)
60
40
20
0
0 1 2 3 4 5 6
time
Figure 11.7 Correlated VG spread paths.
11.5. RECENT DEVELOPMENTS FOR CPPI
CPPIs received and still receive a lot of attention, not only from banks but also from
academia. Here, we try to give an overview of the results discussed in a list of papers.
Three main topics of research can be identified: the behavior of CPPI, limiting the risk,
and building insurances for this risk.
The first group of papers study in detail the behavior of CPPI strategies under spe-
cific conditions for the underlying portfolio. One way of pricing was already presented
in detail in the previous section.
The next group of papers try to measure the risk factors involved. In the first paper
discussed here, an upper bound for the multiplier m is searched for in such a way that
the investment in the risky portfolio is maximized under the condition that the gap risk
must stay under a certain limit. The second discussion presents an extended way to
calculate the VaR and GVaR of the CPPI portfolio.
The last group of papers concentrate on possible ways of extending the CPPI in
such a way that an insurance against the small but existing gap risk is build in. The
price and size of such an extra insurance will depend on the probability of hitting the
floor and hence ways to quantify this risk are also discussed.
For each of the groups, we discuss one example in more detail in the following
three subsections.
11.5.1. Portfolio Insurance: The Extreme Value Approach

to the CPPI Method
In this paper, published by Bertrand and Prigent [18] in 2002, extreme value theory
(EVT) is applied to CPPIs. They aim to find a multiplier as high as possible while
ensuring that the portfolio value will always be above the floor at a given probability
level (typically 99%). If the obtained multiplier is applied, in practice one would
maximize its risk under the constraint that the gap risk stayed below a certain level
(here 1%).
The methods applied in the paper focus on the opposite of the relative jump of the
risky asset at time t + 1:
St − St+1
Xt+1 = .
St
To determine an upper bound for the multiplier, we only need to concentrate on the
positive values of X.
First a general and very strong upper bound for m is constructed which is then
relaxed considering different assumptions. The proposed methods are then applied to
calculate empirical estimates for the upper bound for m using S&P 500 index during the
period January 1969–September 1997 as risky assets under the different assumptions.
As an initial step, it is shown that in order to keep the cushion positive at all times
the upper bound on the multiple needs to be the following:
1
m≤ ,
maxk≤n (Xk )
where n indicates the size of the dataset. This strong condition is then relaxed by
applying quantile hedging. In order to get a result for the multiplier, the possible
values of Xk are first truncated to the interval [a, b] and Xk[a,b] denotes the truncated
jumps (Xk 1a≤Xk ≤b ) with their corresponding arrival times Tk[a,b] (i.e., the sequence of
times at which Xt takes values in the interval [a, b]). The values of a and b will be
chosen in such a way that the values of Xk will all fall in the interval. It is assumed that
inter-arrival times of the truncated values are exponentially distributed with parameter
λ[a,b] . Under this condition, it is concluded that
1
m≤ ,
F [a,b]−1 1 + ln(1−)
λ[a,b] T
where T is the length of the time period covered and F [a,b] denotes the distribution
function of the variations Xk .
If the distribution F [a,b] is not known, two different cases can be considered. Either
one can assume that no prior information is available or, alternatively, one might be
able to fix an upper bound due to anticipation. If no historical information is available,
extreme value statistics will be applied on the maximum value of any time period T
(0 < T < T ). EVT states that the distribution of the maximum of n observations
will converge to a limiting distribution with two parameters. After applying maximum
likelihood estimation the parameters of this limiting extreme value distribution, an
approximation of the upper bound of m is obtained. In the other case, where some
prior information is available, a portfolio manager might fix a maximal drop level b
based on his believes. Under this assumption of a maximal drop level, the calculation
of the upper bound for m becomes more complicated but the portfolio manager will
be able to use a higher multiplier m.
Finally, changes of the upper bound under the different assumptions are compared
when using S&P 500 index as a risky asset.
11.5.2. VaR Approach for Credit CPPI

In [19], the authors discuss the need to build an overnight profit and loss distribution of
the portfolio in order to guarantee the capital of a CPPI. Based on this P&L distribution,
one could measure the underlying risks and adjust the multiplier in order to limit gap
risk.
Credit CPPIs strategies invest in risky assets based on an index or single name
CDSs, an index or bespoke tranches or spread options. The latest generation of credit
CPPIs involve generic portfolios of credit derivatives and the credit index alone might
not be a good proxy of the risk. As a solution, it is proposed to measure the impact of
each risk factor separately. The different factors identified are spreads, jump-to-default
and credit correlation, and the possibility of second-order risk factors is also included.
Those should then be combined to get an idea of the global risk.
Next, it is argued that as historical data are often of low quality when looking
at portfolios of credit derivatives (such as CDSs but also CDO tranches). It is not
recommended to use them in order to compute the risks. It might be possible to find
a distribution for each of the risks, using VaR, separately, but not for the sum, hence
GVaR will be used for estimating the risks.
First, the problem of estimating spreadVaR and defaultVaR for a portfolio of CDSs
will be tackled. Here, a model for the spread dynamic is proposed. The correlation
caused by the fact that spreads of CDSs are driven by global, regional, and sectoral
factors is included in order to estimate the profit and loss coming from spread moves.
For the default VaR of a CDS portfolio, the aim is to find the profit and loss coming
from overnight defaults. It is assumed that defaults are correlated through a Gaussian
copula but no detailed discussion is presented in [19].
To finish the discussion, portfolios with CDOs are included. For the spread VaR
and default VaR, the previous results can be re-used. Besides those, also the VaR of
the profit and loss coming from daily moves of the correlation smile is of importance.
Here a model-free approach is proposed.
The above risk measures for each factor are finally combined using GVaR to give
a global estimation of risk. This is supposed to be stable and to offer great netting.
11.5.3. CPPI with Cushion Insurance

In [20], under the assumption that the dynamics of the value of the risky asset follow the
classic diffusion process given in Eq. (11.1), the authors discuss the situation where an
investor does not invest the total amount available but only a part of the initial amount,
qV0 , into a CPPI. He will use the remainder amount, (1 − q)V0 , to create an extra
insurance on the CPPI. This extra insurance will be build in such way that it pays out
a value K in case the value of the CPPI hits an adjusted floor Fta = (F0 + a)ert with
a > 0 and r the continuous interest rate.
As the adjusted floor lies above the initial floor, this protection will avoid creating
gap risk up to a certain level. This approach seems to be acceptable as the adjusted floor
will, first of all, prevent the CPPI portfolio value coming too close to the floor and hence
gap risk will only remain possible in the event of a large downward jump. Second, for
the calculation of the risk exposure a manager will only consider an adjusted cushion
(= price-adjusted floor), which is smaller than the original cushion. These two factors
will make a jump creating gap risk less likely.
The first time the CPPI hits the adjusted floor is denoted as Ta1 . If Ta1 > T , only
qV0 is invested into the CPPI, otherwise at Ta1 the amount K is paid out and will from
then on be invested in the CPPI portfolio together with the current value of the CPPI
portfolio (VTa1 ).
In order to calculate the costs linked to this system, the authors first calculate the
possibility that the CPPI portfolio hits the modified floor under Black’s model, and
hence that the investor will receive the amount K. Using this probability (for given
values of a, m, and q) together with the principle that expected cost and outcome
must be equal, the correct value of K can be computed. Now all the parameters have
been obtained and properties of this investment strategy are studied using the “greeks”.
Greeks are the quantities representing the market sensitivities, the name is used because
the parameters are often denoted by Greek letters. The Delta, for example, measures the
sensitivity to changes in the price of the underlying asset. The paper concludes that the
Delta of the modified CPPI portfolio is similar to one of the simple CPPI portfolio.
Next, the same exercise is performed assuming that the underlying assets dynamics
are not given by Eq. (11.1) but by a Lévy process defined as follows
dSt = St− [µ(t, St )dt + σ(t, St )dWt + δ(t, St )dlt ],
where (Wt )t is a standard Brownian motion, independent from the Poisson process
with measure of jumps (lt )t . It is also assumed that the expected value of jumps in
every finite interval [0, t] is finite and equal to λt (λ ≥ 0).
The paper concludes by extending the insurance in the sense that not only the first
time but every time the CPPI value reaches the adjusted floor, the amount K will be
invested in the CPPI portfolio.
11.6. A NEW FINANCIAL INSTRUMENT: CONSTANT

PROPORTION DEBT OBLIGATIONS
Constant Proportion Debt Obligations (CPDOs) first appeared in August 2006 and are
a variation on the CPPI structure. They are used for credit portfolios comprising the
exposures to credit indices such as CDX and iTraxx. The CPDO’s risk exposure, just
as with the CPPI, is determined using a constant proportion approach and rebalances
its portfolio between the credit portfolio and a safe asset. The CPDO structure does
this with the aim of producing a high-yielding “AAA”-rated product.
A CPDO funds itself through the issuance of long-term debt paying timely coupon
and principal on the notes. The promised coupon is a spread above for example LIBOR.
The combination of a high coupon payment and the high rating have made CPDOs
very popular products.
First, we will try to explain the structure in detail. CPDOs are currently also a
popular topic in the news and a small overview is provided the next subsection. This
section is concluded presenting an example on rating of CPDOs.
11.6.1. The Structure

Constant Proportion Debt Obligations are structures which use, as suggested by their
name, a constant proportion approach for their risk exposure and re-balance their
portfolio at every time step between the credit portfolio and a safe asset. The CPDO
structure takes leveraged exposure to a risky asset by selling protection on individual
names or indices (CDS or indices on CDS). The risky exposure ensures that there is
enough spread to meet the promised liabilities and also covers the costs and potential
losses that the transaction will absorb.
Risk positions will be taking in function of the value of the CPDO. If the structure
is not performing well, it will increase its risk exposure (up to a pre-defined max-
imum leverage level) in order to allow for recovery from the negative performance
by increasing the income from the risky asset to rebuild the portfolio’s value. The
following factors play a key role in the risk strategies an investor will take:
• Net Asset Value (NAV ): This is the current value of the CPDO. It will be the sum
of the safe investment and the market value of the risky portfolio.
• Riskfree: The amount of the total CPDO value invested in a risk-free way.
• PV(liabilities): The present value of the current liabilities will be the sum of all
discounted coupons still to be paid and the discounted value of the final principal
amount.
• Shortfall: The shortfall is the capital, which is missing to fulfill all the future obliga-
tions. It is defined as the difference between the present value of the liabilities and
the net asset value,
Shortfall = PV(liabilities) − NAV.
• CDS premium: The premium is the amount to be paid to the protection seller (such
as a CDS or CDS index) in exchange for the insurance. An increasing value of
the spread refers to an increased default probability of the underlying asset and
hence it will be negative as a default will lead to a decreasing NAV . Conversely, an
increasing spread results in a higher income.
• PV(CDS premium): The present value of all future premium payments up to matu-
rity.
• Leverage: The leverage refers to the degree of risk which will be taken at each time
step. A maximum level is often fixed at 15. The leverage is hence defined as

Shortfall
Leverage = min β , max(Leverage) , (11.6)
PV(CDS premium)
where β is a multiplier. Similar as in [21], page 18, in this document β will be fixed
at 1/Riskfree.
• Cash-in: In case the NAV is equal to or exceeds the target value (PV(liabilities)),
the necessary amount to cover all future liabilities is reached and hence the risky
exposure and leverage will be put to zero. From this point onwards the NAV will
be completely invested at the risk-free rate, with coupon and fees being paid until
maturity.
• Cash-out: if there are substantial losses and the NAV falls below a certain thresh-
old (often fixed at 10% of the initial investment), it will be said that cash-out has
occurred. In such a situation, the CPDO will unwind and the investor will receive
the remaining value.
The investment strategy follows the following steps. At every time-step, one should
check the discounted value of the future obligations (coupon and principal payment),
which is the amount which one tries to reach.
Next, as the CPDO exposes itself to risk by selling protection (CDSs or CDS
indices), the mark-to-market of this risky investment is checked and compared to the
price paid at the previous time step for this investment. An increase in the spread of the
risky CDS means that the underlying insurance has become more expensive and linked
to this it has become more likely that the seller of the protection will have to cover a
future loss. Compared to the previous time-step, this can be considered as a loss for
the protection seller, as he appears to be underpaid for the protection it provides, and
a gain for the protection buyer.
Besides this gain or loss linked to the protection spread, the costs (or incomes)
related to the protection also need to be taken into account. Those costs are referred to
as the fee which is equal to the sum of all the CDS premium payments made by the
protection buyer for the insurance within the time step, taking into consideration the
possibility of a default event.
The total value of the CPDO (NAV ) at time t + 1 will hence be equal at the
accumulated value of the cash, invested risk free at time t, plus the value of the
risky asset at time t + 1 augmented with the gains (or losses) made by investing
and the fees collected (or paid) for the insurance in the time period [t, t + 1]. From this
value, we should subtract the coupon payments which need to be made to the CPDO
investor.
Based on the above value, and before going to the next step, the new leverage is
determined and according to this leverage new investment positions are taken in the
risky asset(s). If the NAV increases, the shortfall decreases and hence the leverage will
go down; whereas if the NAV decreases, the shortfall will increase and the leverage
will go up in order to try to fix the previous negative performance.
The above steps are repeated at each time step until cash-in or cash-out occurs,
or until maturity. As described in the definition, cash-in occurs when the total value of
the CPDO reaches or exceeds the current value of the future obligations. In this case,
the seller of a CPDO is sure to be able to fulfil all its future obligations and will from
then on only invest in a risk-free way. The probability for a CPDO that such an event
takes place will have a big impact on its rating. Cash-out occurs when the value of the
CPDO hits or shoots below a lower bound which is fixed at time t = 0. If this happens,
the CPDO will unwind and the investor will receive the remaining proceed. Such an
event could be called the gap risk and is comparable to the gap risk of a CPPI. The risk
of a cash-out event cannot be excluded, since in case of under-performance more risk
will be taken, which increases even more the possibility of arriving below the lower
bound when a downward jump occurs.
A similar situation as in Sec. 11.3 is used in order to present the CPDO functioning
in an example. For the risky asset, a CDS-index is considered with starting spread
S0 = 100, and the spreads follow the same Variance Gamma model as before. The
risk-free interest rate is fixed at r = 5%. For the CPDO structure, the coupon payment
is fixed at r + 2% and the maximum leverage is equal to 15. In this example, a cash-out
level of 10% of the initial investment is considered. Figure 11.8 presents two examples
of possible scenarios of a CPDO. In the left column, the target level is reached before
maturity at time t around 8 from that point onwards all cash will be invested in a
risk-free way. For the second example, in the right column, the CPDO value will drop
May 12, 2010
288
17:47
0.06 0.2
Spread Spread
0.04
WSPC/SPI-B913
0.1
0.02
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
150 150
CPDO
100 100 Target
CPDO Cashout
50 Target 50
Cashout
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
60 150
Shortfall Shortfall
40 100
20 50
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
6 6
Leverage Leverage
4 4
2 2
b913-ch11
Joossens and Schoutens
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Figure 11.8 Value of the risky asset (CDS index) (first graph); the corresponding CPDO performance (second); shortfall at each time step (third)
and leverage taken at each time (final) in case of a cash-in situation (left) and a cash-out situation (right).
FA
below the cash-out level just before time t = 5. This is similar to what, in the CPPI
case, we refer to as a gap. If such an event occurs, the CPDO will unwind and the
investor will receive all remaining cash.
In practice, risk positions will almost always be taken in CDS indices (iTraxx
and CDX). The benefits of this choice are summarized on Slide 10 of [22]. However,
questions about safety in the sense of the correctness of the high triple-A rating do
remain and this sensitive topic will be discussed in the next two subsections. Some
literature on CPDOs can be found in [21, 23–28].
11.6.2. CPDOs in the Spotlight

Recently, it has become clear that CPDOs are not as safe as is often thought. In real
life, cash-out events have occurred and these events have also received attention in the
media. As a result, the safety of CPDOs has been put up for discussion.
On 16th November 2007, for example Moody’s Investors Service downgraded its
ratings on six CPDOs, one even to a “junk” rating of Ba2. The downgrading was done
because of the continuing spread widening on the financial names underlying these
CPDOs.
On 28th November 2007, the first CPDO unwinding was announced. This unwind-
ing shows the controversial credit product’s potential for volatility, and moreover it has
raised the question of whether the probability they will pay off is as high as implied
in a triple-A rating.
And also more recently, on 25th January 2008, Moody’s Investors Service confirms
that two more series of notes from structured deals backed by financial companies were
liquidated after losing investors approximately 90% of their investment. Besides the
two unwindings, it also discusses a list of downgrading which has occurred.
Many more cases of downgrading and even unwinding have taken place in the
last year.
11.6.3. Rating CPDOs Under VG Dynamics

A short example has already been presented in this section to explain the dynam-
ics of the CPDO structure. In this section, another example is presented in which
positions are taken in two high correlated indices: the iTraxx (iTraxx Europe Main
on the run (5 years) unfunded) and CDX (DJ CDX.NA.IG Main on the run (5 years)
unfunded). As trading position, we will always invest half of the risky exposure in each
index.
As presented in [8] and discussed in detail in Sec. 11.4, a Multivariate Variance
Gamma model is used to model a series of correlated spreads. First, the calibration is
performed using swaption prices based on those indices in order to construct a model
100
iTraxx
CDX
50
0
0 1 2 3 4 5 6 7 8 9 10
150
CPDO
100 Target
Cashout
50
0
0 1 2 3 4 5 6 7 8 9 10
30
Shortfall
20
10
0
0 1 2 3 4 5 6 7 8 9 10
15
Leverage
10
0
0 1 2 3 4 5 6 7 8 9 10
Figure 11.9 First graph: value of the risky asset (CDS index); second: the corresponding
CPDO performance; third: shortfall at each time step; final: leverage taken at each time.
for their dynamics. The resulting model is then applied to simulate the evolution over
time of a CPDO.
Assume that the risk-free interest rate is fixed r = 0.04. For the CPDO structure
the coupon payment is fixed at r + 2% and the maximum leverage is equal to 15.
The initial quotes for our portfolio are iTraxx is quoted 24.625 bp and CDX is quoted
37.5 bp. The top graph of Fig. 11.9 presents a typical picture of the correlated spread
evolution under the multivariate VG jump dynamics, which is obtained after calibra-
tion. The corresponding path of the CPDO is presented in the second graph and the
third and fourth graphs present the corresponding shortfall and leverage positions at
each time.
In most of the current research documents, it is considered that the spreads follow
a Brownian motion which do not allow sudden jumps and hence it is less likely to hit
the barrier. If jumps are present in the spread dynamics, the value of the portfolio can
suddenly jump under the floor. Based on 10,000 Monte Carlo simulations using the
model as obtained from the calibration, we find that the likelihood of occurrence of a
cash-out event is around 1.94%, which is not as negligible as might be suggested in
the literature. It looks that this percentage is closer to what is also observed in practice,
as discussed before.
11.7. COMPARISON BETWEEN CPPI AND CPDO
When CPDOs were created, they were considered as a variation of the CPPI. They
borrow certain features such as a “constant proportion” approach to determine the
leverage and the re-balancing of the portfolio between the credit portfolio and the safe
asset.
On the other hand, they are also very different. Initially, the CPDO value will
be below the target value, while the CPPI manager tends to invest only the amount
exceeding the floor, which is needed to make the principal payment at maturity in a
risky way. Once decisions on the risky exposure need to be taken the idea is that a
CPDO investor will increase its risk as it is performing negatively while the CPPI will
decrease its risk as it is not performing well and approaches the floor level. In other
words, at each time step, the CPPI investor takes risk exposure positions based on the
amount of surplus the portfolio value has with respect to the floor value. The CPDO
investor, on the other hand, will at each time take risk exposure proportional to the
amount the CPDO portfolio is lacking in order to reach the target value.
Once the CPDO value reaches the target value, the manager will stop investing
in a risky way as there is sufficient capital to pay out all future liabilities and there is
no more need to create capital in a risky way. A CPPI manager will try to optimize its
profit but will stop taking risk at the moment that the CPPI value touches the floor, as
he is afraid to fall below by taking more risk.
Also the behavior at the final stage of the contract is different. A CPPI will,
at maturity, irrespective of the performance of the risky asset, receive the principal,
together with any positive return generated from the risky asset. In case of loss, when
the CPPI portfolio falls below the floor, the losses are covered by the seller of a CPPI
so that the investor will still receive the principal. An investor can hence always be sure
of receiving the principal and, in the case of good performance, even more. For the
CPDO, on the other hand, a target value is aimed for and in the case of a sufficiently
well performing risky asset a cash-in event will occur and the investor will receive all
promised coupon and principal payments. But when the risky asset does not perform
well and a cash-out event occurs, the CPDO will unwind before maturity. In such a
situation only the remaining amount will be paid out to the investor. Investors will
want to know the size of this risk at the time of investing in a CPDO and they will
use its rating as an indication. This way, the rating of a CPDO becomes important and
will have an effect on the price of a CPDO. In practice, the risk of a cash-out event has
apparently been under-estimated.
11.8. CONCLUSIONS
As the market of structured credit products grew over the last years, also the request
of protection mechanisms in structured credit transactions stays high and hence, also
here, a continuous evolution can be observed. CPPI and CPDO are recently developed
alternative investment strategies which aim to provide a protection.
CPPIs first came into use around 10 years ago and promise a pre-defined principal
payment at maturity. A constant proportion rule is applied to decide the investment
strategy. At every time step, the investment in the underlying risky asset and the safe
asset is re-balanced in order to optimize the profit.
CPDOs were introduced in 2006 and are intended to be safe, high-yielding instru-
ments. A similar constant proportion rule is used for their investment strategies and
they will invest in a risky asset by selling protection (such as CDX and iTraxx). Simi-
larly to the CPPI, re-balancing will be done at every time step until the targeted value
has been reached.
The aim of this chapter was to create an in depth view of the dynamics and risks
linked to both alternative investment strategies. Hence, first we have tried to explain
step by step how they both function and how investment decisions are made.
Understanding the dynamics well helps to identify remaining “safety gaps” and
allows an investor to get an idea about the size and possibility of experiencing such a
gap. For the CPPI, the possibility that the value of the total portfolio will fall below the
floor exists and will create a loss, while for the CPDO a loss occurs when a cash-out
event occurs.
In both cases, there is a strong interest in quantifying this risk. In a first group of
papers, the researchers concentrate on quantifying the risk using specific conditions.
Next, some propose ways to limit the multiplier factor in order to limit the risk, while
other papers suggest the possibility of investing on an insurance to cover this risk.
But also for those new developments a good and robust way of quantifying the risk is
necessary. It could be concluded that the gap risk for CPPIs should not be neglected
but safety nets can be used to avoid suffering from it.
As CPDOs are still very new, the field of research is still limited, and as they have
only been used on the market for a couple of years, their performance in the real world
has only been observed over a short time. As recent experience has shown, in real life
CPDOs do not seem to be as safe as they were expected to be. Clearly, there is still a
strong need to quantify the risk of cash-out events in a more realistic manner, and a
great deal of research remains to be done in this field.
References
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Wiley & Sons.
[2] Cariboni, J (2007). Credit Derivatives Pricing Under Lévy Processes. PhD thesis,
Katholieke Universiteit Leuven.
[3] Madan, D and W Schoutens (2007). Break on through to the single side. Technical Report,
Section of Statistics Technical Report 07-07, (2007). URL http://perswww.kuleuven.be/
∼u0009713/LevyCDS.pdf.
[4] Overhaus, M, A Bermudez, H Buehler, A Ferraris, C Jordinson and A Lamnouar (2007).
Equity Hybrid Derivatives. John Wiley & Sons.
[5] Black, F and R Jones (1987). Simplifying portfolio insurance. Journal of Portfolio Man-
agement, 48–51.
[6] Perold,A (1986). Constant portfolio insurance. Unpublished manuscript, Harvard Business
School.
[7] Cont, R and P Tankov (2007). Constant proportion portfolio insurance in presence of jumps
in asset prices, SSRN eLibrary. URL http://ssrn.com/paper=1021084.
[8] Garcia, J, S Goossens and W Schoutens (2008). Let’s Jump Together: Pricing of Credit
Derivatives. Risk Magazine, September.
[9] Madan, D and E Seneta (1990). The variance Gamma model for share market returns.
Journal of Business, 63, 511–524.
[10] Bertoin, J (1996). Lévy Processes. Vol. 121, Cambridge Tracts in Mathematics, Cambridge:
Cambridge University Press.
[11] Sato, K (2000). Lévy Processes and Infinitely Divisible Distributions. Cambridge Univer-
sity Press.
[12] Seneta, E (2007). The early years of the variance-gamma process. Advances in Mathemat-
ical Finance. Boston: Birkhäuser.
[13] Cariboni, J and W Schoutens (2004). Pricing credit default swaps under Lévy models.
UCS Report 2005-02, K. U. Leuven.
[14] Luciano, E and W Schoutens (2006). A multivariate jump-driven financial asset model.
Quantitative Finance, 6(5), 385–402.
[15] Leoni, P and W Schoutens (2008). Multivariate smiling, Wilmott Magazine, March Issue.
[16] Pederson, C (2004). Introduction to Credit Default Swaptions, Lehman Brothers.
[17] Carr, P and D Madan (1999). Option pricing and the fast fourier transform. Journal of
Computational Finance, 2(4), 61–73.
[18] Bertrand, P and J Prigent (2002). Portfolio insurance: The extreme value approach to the
CPPI method. Finance, 23(01A13), 68–86.
[19] Brun, J and L Prigneaux (2007). VaR approach for credit CPPI and counterparty risk.
Quant Congress, Quant Congress.
[20] Prigent, JL and F Tahar (2005) CPPI with cushion insurance. SSRN eLibrary. URL
http://ssrn.com/paper=675824.
[21] Standard&Poor’s (2007). Quantitative modeling apporach to rating index CPDO struc-
tures. Technical Report, Standard&Poor’s.
[22] ABN-AMRO (2007). Surf CPDO: A breakthrough in synthetic credit investments. Struc-
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12
ON THE BENEFITS OF ROBUST
ASSET ALLOCATION FOR CPPI
STRATEGIES
KATRIN SCHÖTTLE∗,‡ and RALF WERNER†,§

∗
MEAG MUNICH ERGO AssetManagement GmbH,
Oskar-von-Miller-Ring 18, 80333 München, Germany
†
Hypo Real Estate Holding AG,
Unsöldstrasse 2, 80538 München, Germany
‡
katrin.schoettle@gmx.de
§
werner_ralf@gmx.net
In recent years, new ideas for the robustification of the traditional Markowitz frontier
have appeared in the literature. Based on one of these ideas — the so-called robust
counterparts — we introduce the concept of the robustified efficient frontier. As mean–
variance efficient portfolios are frequently used as risky assets for CPPI strategies,
we investigate the behavior of such strategies under estimation risk. Based on a toy
example, we explain the main idea how the concept of a robustified frontier can be
used to improve the performance of CPPI strategies. For this purpose, we compare
the theoretical performance of CPPI strategies based on the original and the robust
efficient frontier.
295
296 Schöttle and Werner
12.1. MOTIVATION
During the last years, dynamic investment strategies have gained more and more impor-
tance in quantitative asset management. Until now, traditional asset management was
mainly based on the choice of a strategic asset allocation (SAA), which has been fixed
for one year in most cases. Nowadays, there is a move toward dynamic asset alloca-
tion (DAA), mainly driven by portfolio insurance concepts and the influence of option
pricing theory on investment strategies, like the best-of-two concept of [9]. Further, it
has been observed that the utilization of a dynamically rebalanced allocation allows
for a better-tailored risk/return profile for the investor, as described in [1].
In the following study, we focus on one of the most popular portfolio insurance
concepts — a constant proportion portfolio insurance (CPPI) strategy. This concept
was probably first introduced by Perold in 1986, see [24] (see also [25] as well as [5]),
followed by a large variety of theoretical and empirical studies, comparison to alter-
native strategies, etc. For a recent and extensive overview of related work, we refer to
the book [27], Chapter 9 and the references therein. Meanwhile, the properties as well
as the pros and cons of CPPI like strategies are well known and discussed in detail,
see also [27], Chapter 9. However, in our opinion, one rather relevant practical issue
has not yet found much attention by researchers — the influence of estimation risk
on the performance of CPPI strategies. In contrast to this observation, there is a good
amount of research on the influence of estimation risk on static one-period mean–
variance optimization, see [8] and the references contained therein. Hence, we focus
on the investigation of the influence of this estimation risk on the performance of CPPI
strategies as well as a mitigation of this risk by the robustification of mean–variance
efficient portfolios.
The remainder of this paper is organized as follows: first, we introduce the tradi-
tional CPPI strategy. A few numerical examples will show that the choice of the risky
asset has a significant impact on the investment performance of the CPPI strategy
and that especially the allocation according to mean–variance optimal portfolios adds
value to the strategy. Thereafter, it is shown that this behavior may deteriorate in the
presence of estimation risk. Therefore, robustified mean–variance efficient portfolios
are introduced and their impact on the investment performance is investigated.
12.2. THE FINANCIAL MARKET
In contrast to most academic research, our exposition is based on a discrete time frame-
work instead of a continuous time setting. This setup was chosen for several reasons.
First, in continuous time, CPPI strategies only exhibit a shortfall risk in the presence
of discontinuous price paths (i.e., in jump models). Second, estimation risk is much
Robust Asset Allocation for CPPI Strategies 297
more important in discrete time. Third and most important, practical implementations
are always based on discrete time setups.
12.2.1. The Basic Financial Market

In order to properly formulate the standard CPPI strategy and to highlight the afore-
mentioned issues with this strategy, we introduce the following basic financial market.
Definition 12.1. Let us assume that we are given a discrete time arbitrage-free financial
market (, F, F, P) with time steps t and final horizon T . Further, assume that on
this market, there are I tradeable assets, e.g., stocks, bonds, or equity indices, with
prices {St }t=0,...,T , St ∈ R+
I
following some adapted (discrete time) stochastic process.
This process will be specified in more detail in Assumption 12.3.
Remark 12.2. Please note that the probability measure P represents the true real world
measure and should not be confused with some martingale measure. Furthermore, we
do not assume that the market is complete.
Assumption 12.3. For the remainder of this paper, we will assume that the discrete
one-period asset returns St are i.i.d. in time and follow a multivariate elliptically
contoured distribution, i.e.,
Si,t − Si,t−t
St ∼ E(µ, , ψ) with Si,t := (12.1)
Si,t−t
independent of t, with parameters µ ∈ R+
I
, ∈ SI+ , and characteristic generator ψ

with 2ψ (0) = −1. Further, we assume that St is bounded, i.e.,
St ∈ [µ − 1 , µ + 1 ], especially St > −11.
Since St is bounded, it possesses finite moments, which means that

E[St ] = µ, Cov[St ] = −2ψ (0) =
and the characteristic function of St −µ is given by u → ψ(u u). For more details
on elliptical distributions, we refer to [11] or [10].
Remark 12.4. In Assumption 12.3, the one-period mean µ and covariances are
used to describe the distribution of St . However, if not explicitly stated otherwise,
all tables and figures are scaled to annualized numbers through division by t.
Remark 12.5. We need to point out that the usual assumption of multivariate nor-
mal (or student t) returns contradicts the assumption of St ∈ R+ I
. We have cured
this by restricting the distribution of St to [µ − 1 , µ + 1 ]. For practical purposes,
P[Si,t ≤ −1] is negligibly small anyway for sufficiently small t, even if we were
in a multivariate normal or student t framework.
As we want to focus on estimation risk, we assume in the following that the char-
acteristic generator ψ is known (i.e., no model risk is involved) but that the parameters
µ and are not given a priori. Hence, one has to rely on estimators for these quantities.
Therefore, we will only consider parameter uncertainty and no model uncertainty for
the ease of this exploration.
For the formulation of the standard CPPI strategy, we need to make some addi-
tional assumptions about the financial market. First, we introduce two riskless assets
in the financial market; a cash account and a zero bond. Second, we define what in
practice is known as a risky asset. Whereas the cash account and the zero bond enhance
the financial market by two additional assets, all risky assets will be completely repro-
ducible by the existing tradeable assets (see Formula (12.2) below) and do therefore
not enlarge the market.
12.2.2. The Riskless Asset

Assumption 12.6. As mentioned above, on top of the described assets, we need the
following additional (locally) riskless assets:
• The market includes a cash account, also called (locally) riskless asset. For brevity
and notational convenience, we denote the process of the cash account with Ct
instead of including it in the already defined process St . The main feature of the
cash account is that
Ct+t = exp(rt t)Ct , t = 0, . . . , T − t,
where the one-period rate rt is assumed to be known at time t, hence Ct+t is
Ft -measurable, i.e., predictable. In this sense, we may speak of the cash account as
locally riskless asset.
• The market is equipped with a zero bond Zt with maturity T , i.e., ZT = 1. Although
the price evolution of this zero bond is stochastic in its very nature, zero bonds are
still subsumed within the class of riskless assets as the payment at maturity is known
in advance.
We will see in the following that for the standard CPPI strategy, only the zero bond
Z is actually necessary, the cash account C will only become important when dealing
with the problem of inter-temporal risk budgeting or in case of general liabilities, see
Remark 12.20.
12.2.3. The Risky Asset

As risky asset, we understand a basket consisting exclusively of the original I
assets building the basic financial market. In general, the risky asset is assumed
to have a constant asset mix, i.e., it is described by a constant vector of weights

w ∈ R+ I
, w1 = 1 (i.e., no short sales are allowed). The risky asset is usually deter-
mined by the client of the asset manager or the asset manager herself and remains
fixed throughout the whole investment period. In order to obtain fixed weights, a per-
manent rebalancing in this risky asset has to be assumed. In this sense — as already
mentioned above — the risky asset can be seen as a mutual fund, which is constructed
within the financial market. The risky asset is usually established at the inception of
the CPPI strategy and remains fixed throughout the life time. Under the assumption of
rebalancing at each time t, the price process {Xt }t=0,...,T of the risky asset is given by
Xt+t = Xt · (1 + wSt+t ) t = 0, . . . , T − t. (12.2)
In analogy to St in Eq. (12.1), we set

Xt − Xt−t
Xt = , and
Xt−t
µX := E[Xt ] = w µ,
σX2 := Cov[Xt ] = ww.
Please note that due to w ∈ R+I

it holds that Xt is bounded as well, i.e., Xt ∈
[µX − 1, µX + 1], and especially Xt > −1.
Remark 12.7. In practice, there are a few different ways how the asset allocation for
the risky asset can be determined:
• The most simple way uses the naïvely diversified portfolio, i.e.,

1 1 1 1
w= ,..., = 1, i.e., wi = .
I I I I
This portfolio is often used as a benchmark against which other methodologies are
tested and compared. The advantage of this choice is that it does not rely on any
estimate of future returns or volatilities (i.e., covariance matrix of asset returns).
• More sophisticated allocations are based on the traditional Markowitz optimization.
At the inception of the CPPI strategy (i.e., at t = 0), an asset allocation is chosen
from the efficient frontier based on mean–variance optimization. For this approach,
estimates for the expected returns µ and the corresponding covariances need to
be available. Given these estimates, superior investment results should be obtained
due to the usage of efficient portfolios. The most popular choices are
— The global minimum variance portfolio
— The maximum Sharpe ratio portfolio
More details on the setup of the mean–variance optimization will be given in the next
subsection.
Besides these initially fixed asset allocations, dynamically updated allocations are
also possible within the framework of CPPI strategies. As these are also subject to the
same estimation issues as the above myopic portfolio choice, we later focus on this
simple myopic setup.
12.2.4. Classical Mean–Variance Analysis

The traditional mean–variance optimization was first introduced by Markowitz in 1952,
see [21]. The basic idea is that a portfolio is solely characterized by the two figures risk
(mostly measured in terms of the variance or volatility) and expected return. Since an
investor is seeking for an allocation with little risk and high expected return, a trade-off
between these two conflicting aims has to be made. In many practical applications, the
set of assets describing the financial market is supposed to stem from a multivariate
normal distribution, where the expectation and covariance matrix thereof are then
used to express the risk and return of the portfolios in the optimization problem.
The Markowitz approach is naturally applicable as well in the more general case of
multivariate elliptical distributions, see [15].
In the following, we use the Markowitz optimization framework to determine
particular portfolios from the efficient frontier, which are then used as underlying risky
asset in CPPI strategies. The asset universe under consideration consists of the initial
I tradeable assets only. As we will see, the move to efficient portfolios of tradeable
assets has a beneficial impact on the performance of the CPPI strategy.
To determine all efficient portfolios, i.e., portfolios lying on the efficient frontier,
we consider the following family of portfolio optimization problems:
Definition 12.8. The classical mean–variance portfolio optimization problem is

given by
√
min (1 − λ) ww − λw µ, (Pλ )
w∈W
where W ⊂ {w ∈ RI | w1 = 1} is assumed to be non-empty, convex, and com-

pact. This is, for example, fulfilled by W = {w ∈ R+ I
| w1 = 1}, which will be
used in the following. The parameter λ ∈ [0, 1] expresses the trade-off between risk
(i.e., volatility) and return of the portfolio. The optimal solutions w∗cl (λ) of (Pλ ) for
given trade-off parameter λ span the efficient frontier

w∗cl (λ)w∗cl (λ), w∗cl (λ) µ
0≤λ≤1
in the (σ, µ)-diagram, see Fig. 12.1.

0.11
0.105
0.1
Excess return (p.a.)
0.095
0.09
Efficient frontier
0.085
Min. variance portfolio
Naive portfolio
Max. sharpe ratio portfolio
0.08
0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22
Volatility (p.a.)
Figure 12.1 Markowitz efficient frontier and selected portfolios.
Remark 12.9. Based on the assumption that W ⊂ {w ∈ RI | w1 = 1} and since is

positive definite, it is easy to show that there exists at least one solution for 0 ≤ λ < 1
and that the solution w∗cl (λ) is indeed unique, see [29].
Remark 12.10. Two portfolios have been of particular interest thus far:
(1) The minimum variance portfolio w∗cl (0), i.e., the portfolio at the left end of the
frontier where λ = 0
(2) The maximum Sharpe ratio portfolio — in this context — given by w∗cl (λS ) where
w∗cl (λ) µ
λS = arg max .
λ∈[0,1] w∗cl (λ)w∗cl (λ)
We have illustrated both portfolios together with the naïve portfolio in Fig. 12.1.
Remark 12.11. Under the above assumptions, problem (Pλ ) is equivalent to the clas-
sical Markowitz formulation
max w µ (MVσ )
w∈W
s.t. ww ≤ σ 2 ,
where σ and λ are in a monotonous one-to-one relationship. For an exact definition of
the equivalence, we refer to [32].
12.2.5. The Trading Strategy

For the mathematical definition of a self-financing trading strategy in the above market
setup, let us refer to [12], Sec. 5.1. Our setup differs only in notation from their
framework, as we prefer that at time t the portfolio composition (holdings or lot sizes)
ϕt ∈ RI+3 shall denote the holdings after trading at time t. This means that the portfolio
allocation remains constant throughout the period [t, t +t[ and equals ϕt . A particular
trading strategy is thus determined by the way the portfolio composition ϕt ∈ RI+3
at time t is determined based on known quantities at time t. Seen as a stochastic
process, this means that ϕt is an Ft -measurable process, i.e., adapted. For notational
convenience, we split the trading strategy ϕt ∈ RI+3 into several components, based
on the underlying assets:

ϕt = ϕtS , ϕtC , ϕtZ , ϕtX ∈ RI × R × R × R
for the first I tradeable assets S, the cash acount C, the zero bond Z, and the risky asset
X, resp.
Remark 12.12. In the following, the CPPI strategy will only invest in the zero bond
and in the risky asset, i.e., we have ϕtS = 0 as well as ϕtC = 0. Nevertheless, the
tradeable assets S are required to construct the risky asset X.
Definition 12.13. Let us further introduce a few notations:
• The corresponding portfolio value at time t is given as

Vt := ϕtS St + ϕtC · Ct + ϕtZ · Zt + ϕtX · Xt .
• Let us denote the difference in the holdings before and after trading, the traded
lots, as
ϕt := ϕt − ϕt−t .
• The corresponding trading volume at time t can be computed as

I
vt := |ϕi,t
S
| · Si,t + |ϕtC | · Ct + |ϕtZ | · Zt + |ϕtX | · Xt .
i=1
12.3. THE STANDARD CPPI STRATEGY
Based on the riskless and the risky asset, we can define the main features of a CPPI
strategy. Its core idea lies in the dynamic allocation of capital between the riskless and
the risky asset. The proportion of the riskless asset in the portfolio is chosen in such
a way that a prespecified minimum level of wealth is guaranteed at time T . This final
minimum level of wealth Vmin is called floor. In general, it is expressed in absolute

terms or relative to the initial wealth V0 :
1
Vmin := f · V0 , with 0 < f < , (12.4)
Z0
for example f = 0.95, 1.00, 1.02, . . . . The condition f · Z0 < 1 stems from the
absence of arbitrage in the financial market. It is easy to see that investing Lt := Vmin ·Zt
into the zero bond Z at time t yields a final wealth of at least Vmin . This observation is
the basis for the simple version of the CPPI strategy.
12.3.1. The Simple Case

Algorithm 12.14. Given all information at time t, the most simple CPPI strategy can
then be stated as follows:
(1) Compute the present value of the floor Lt = Zt · Vmin = f · Zt · V0 .

(2) Compute the exposure Et := (Vt − Lt )+ .
(3) Invest Vt − Et in the zero bond and Et in the risky asset, i.e.,
Et V t − Et
ϕtX = , ϕtZ = .
Xt Zt
Let us start with a feasible initial value of the floor L0 , cf. (12.4). Then it holds V0 >
E0 = V0 − L0 > 0 and therefore
E0 V0 − E0 L0
ϕ0X = , ϕ0Z = = = Vmin .
X0 Z0 Z0
A closer investigation of the simple CPPI strategy yields that — independent of the
returns of the risky asset or the zero bond — the lot sizes ϕtZ remain constant over time:
ϕtZ = ϕ0Z = Vmin . Therefore, since the strategy is self-financing, it must also hold that
ϕtX = ϕ0X . This means that in its simple version the CPPI strategy does not need to
rebalance the portfolio — here we mean rebalancing between riskless and risky asset,
the risky asset itself may of course need some rebalancing.
Remark 12.15. In general, the above simple CPPI strategy is not very well suited to
achieve the returns exceeding the risk free rate. Table 12.1 illustrates that although
the underlying risky asset has a rather broad annual return distribution ranging at least
from −0.20 to 0.50, the annual return of the CPPI remains within tight bounds from
0.01 to 0.06. This is immediately clear from the property of the simple CPPI strategy
that it is just a buy-and-hold strategy between the zero bond and the risky asset, i.e., at
each time t the fraction fZ0 is invested in the zero bond, whereas only 1 − fZ0 is
Table 12.1 Performance of Selected Rebalancing and CPPI Strategies.a
Strategy E Std Skewness Excess kurtosis 1% pctl. 99% pctl.
Reb. naïve 0.1192 0.1710 0.4524 0.3603 −0.2255 0.5771

Reb. minvar 0.1196 0.1505 0.4009 0.3275 −0.1903 0.5163
Reb. maxsharpe 0.1290 0.1586 0.4198 0.3217 −0.1953 0.5502
CPPI naïve 0.0374 0.0134 0.4524 0.3603 0.0105 0.0731
CPPI minvar 0.0374 0.0117 0.4009 0.3275 0.0132 0.0684
CPPI maxsharpe 0.0382 0.0124 0.4198 0.3217 0.0128 0.0710
Zero bond 0.0305 — — — — —
a Thistable gives the average performance of the three risky assets and the zero bond in com-
parison to those of the corresponding three simple CPPI strategies (with f = 0.95) based on a
Monte Carlo simulation with 25,000 random paths. Besides the expected performance (E), we
have added the standard deviation (std), the skewness, and the excess kurtosis as well as the
1% and 99% percentile of VT /V0 − 1 for a better comparison.
invested in the risky asset:

L0 V0 − L0 V0 − Z0 · Vmin
Vt = · Zt + · Xt = Vmin · Zt + · Xt
Z0 X0 X0

Zt Xt
= V0 · fZ0 + (1 − fZ0 ) .
Z0 X0
Nevertheless, using more information on the distribution of the return of the risky
asset, the CPPI strategy can be refined to obtain better investment returns.
Remark 12.16. The simulation and optimization setup for the results in Table 12.1
and all subsequent calculations is as follows:
• The continuous risk free interest rate is assumed to be 3% p.a., i.e., the zero bond
has a discrete return of r = 3.05% p.a.
• The excess returns of six individual tradeable assets over the risk-free return of the
zero bond are given by

µann,exc = 4.68%, 10.56%, 6.36%, 10.56%, 9.48%, 8.52% ,
expressed in annualized terms.
• The (annualized) covariance matrix of the financial assets is
 
0.0359 0.0188 0.0122 0.0115 0.0228 0.0199
0.0188 0.0588 0.0322 0.0247 0.0272 0.0158
 
 
0.0122 0.0322 0.0460 0.0182 0.0214 0.0108
ann =  .
0.0115 0.0247 0.0182 0.0590 0.0202 0.0079
 
0.0228 0.0272 0.0214 0.0202 0.0431 0.0172
0.0199 0.0158 0.0108 0.0079 0.0172 0.0220
• The simulations of the discrete one-period asset returns are based on a normal
distribution N (µt, t) with µ = µexc + r. The normal distribution has been cut
off to guarantee Assumption 12.3 in the sense of Remark 12.5 simply by neglecting
any violating scenario.
12.3.2. The General Case

The main idea of the standard CPPI strategy is to leverage the investment in the risky
asset and to actively balance between the risky asset and the zero bond. The leverage
factor m, by which the investment in the risky asset is increased in comparison to the
simple version, is usually called multiplier. The introduction of this multiplier m leads
to the CPPI strategy in its standard form:
Algorithm 12.17. Given all the necessary information at time t, the standard CPPI
strategy can be formulated as
(1) Compute the present value of the floor Lt = Zt · Vmin = f · Zt · V0 .
(2) Compute the cushion or risk budget Bt := (Vt − Lt )+ .
(3) Compute the leveraged exposure as Et := min(mBt , Vt ).
(4) Invest Vt − Et in the zero bond and Et in the risky asset, i.e.,
Et V t − Et
ϕtX = , ϕtZ = .
Xt Zt
Remark 12.18. In the above version, the exposure is bounded by the current portfolio
wealth, however, it is possible to introduce an upper boundary level 0 < b < 1 and to
restrict Et by Et = min(mBt , bVt ).
Remark 12.19. The cap of Et by Vt in the standard CPPI strategy restricts an invest-
ment in the risky asset beyond the wealth of the strategy, i.e., short positions in the
zero bond are prohibited. Note that this cap was not necessary in the simple version
of the CPPI strategy.
Remark 12.20. In more general settings, Lt is not linked to a deterministic zero

bond investment any more, but given by a more general stochastic liability (hence the
abbreviation Lt ). As long as this liability Lt is investable, e.g., by so-called replicating
portfolios, CPPI strategies can still be formulated. For example, if a money market
fund is to be beaten, f · Ct may be chosen as liability.
As we see from Fig. 12.2 and Table 12.2, the multiplier m has a significant influence
on the performance of the investment strategy. We can observe that the average return
E[VT /V0 − 1] increases with increasing m up to a certain level. From there onwards,
no significant increase in average performance is possible. We can also observe that
the standard deviation behaves accordingly.
0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02 Expected Return

Volatility
0
5 10 15 20 25 30
Multiplier m
Figure 12.2 Average return and standard deviation of the standard CPPI strategy on the naïve
risky asset with f = 0.95 for different multipliers m.
Table 12.2 Descriptive Statistics of the Standard CPPI Strategy on the

Naïve Risky Asset with f = 0.95 for Different Multipliers m.
Multiplier E Std Skewness Excess kurtosis
m=1 0.0374 0.0134 0.4524 0.3603

m=3 0.0531 0.0493 1.4819 3.8084
m=5 0.0707 0.0972 1.9288 4.8104
m=7 0.0837 0.1288 1.5671 2.5131
m=9 0.0909 0.1451 1.3436 1.5518
m = 11 0.0944 0.1537 1.2221 1.1190
m = 13 0.0961 0.1585 1.1504 0.8890
m = 15 0.0969 0.1613 1.1012 0.7365
m = 17 0.0973 0.1632 1.0673 0.6338
m = 19 0.0976 0.1645 1.0417 0.5610
m = 21 0.0978 0.1655 1.0227 0.5093
m = 23 0.0979 0.1662 1.0076 0.4701
m = 25 0.0980 0.1667 0.9965 0.4412
m = 30 0.0981 0.1677 0.9761 0.3899
Remark 12.21. This behavior can easily be explained by a deeper investigation of

Algorithm 12.17, Step (3). If the multiplier m is increased step by step, the leveraged
exposure Et will equal Vt as long as there is at least a cushion of Vt /m — which
diminishes to 0 if m → ∞. This means that the CPPI strategy is fully invested in the
risky asset until the risk budget is lost. As soon as Bt ≤ 0, the investment is completely
shifted from the risky asset to the riskless asset. In other words, for m → ∞, the CPPI
strategy converges to a simple stop-loss strategy, which invests into the risky asset
until the wealth is below the floor Lt . As soon as the cushion is lost, the CPPI strategy
cannot recover as it is fully invested in the zero bond for the rest of the time and thus
VT ≤ LT = Vmin .
In contrast to the simple CPPI strategy, for m > 1, it might happen that VT ≤ LT ,
i.e., the floor is no longer guaranteed. This probability of a shortfall is investigated in
more detail in the next subsection. Please note that this cannot happen in continuous
time as long as the price paths are continuous, see [27].
In addition to the multiplier m, also the floor f has a significant impact on the
performance and the risk of the strategy. In Tables 12.3 and 12.4, an overview of the
dependence is given.
It can be observed that with increasing multiplier the expected return of the CPPI
strategy increases, since more capital can be invested in the risky asset which accounts
for higher returns. The same line of argumentation holds for the floor: the lower the
floor, the more budget for riskier investments and thus the higher the expected return.
Table 12.3 Expected Return of the Standard CPPI Strategy on the Naïve Risky
Asset for Different Multipliers m and Different Floors f .
f = 0.90 f = 0.925 f = 0.95 f = 0.975 f = 0.99 f = 1.00
m=1 0.0417 0.0395 0.0374 0.0352 0.0339 0.0331

m=3 0.0672 0.0602 0.0531 0.0461 0.0419 0.0390
m=5 0.0913 0.0816 0.0707 0.0587 0.0512 0.0461
m=7 0.1029 0.0946 0.0837 0.0701 0.0606 0.0537
m=9 0.1072 0.1005 0.0909 0.0776 0.0677 0.0600
m = 11 0.1091 0.1031 0.0944 0.0819 0.0721 0.0644
m = 13 0.1099 0.1043 0.0961 0.0844 0.0747 0.0670
m = 15 0.1103 0.1050 0.0969 0.0854 0.0761 0.0684
m = 17 0.1105 0.1053 0.0973 0.0858 0.0768 0.0692
m = 19 0.1107 0.1055 0.0976 0.0858 0.0769 0.0696
m = 21 0.1107 0.1057 0.0978 0.0858 0.0770 0.0696
m = 23 0.1108 0.1057 0.0979 0.0859 0.0767 0.0694
m = 25 0.1109 0.1057 0.0980 0.0859 0.0765 0.0693
m = 30 0.1110 0.1058 0.0981 0.0861 0.0764 0.0694
Table 12.4 Standard Deviation of the Standard CPPI Strategy on the Naïve Risky
f = 0.90 f = 0.925 f = 0.95 f = 0.975 f = 0.99 f = 1.00
m=1 0.0216 0.0175 0.0134 0.0092 0.0067 0.0051

m=3 0.0799 0.0646 0.0493 0.0340 0.0248 0.0187
m=5 0.1366 0.1191 0.0972 0.0706 0.0527 0.0400
m=7 0.1588 0.1468 0.1288 0.1032 0.0827 0.0665
m=9 0.1660 0.1587 0.1451 0.1229 0.1038 0.0875
m = 11 0.1687 0.1638 0.1537 0.1347 0.1172 0.1017
m = 13 0.1701 0.1664 0.1585 0.1422 0.1260 0.1114
m = 15 0.1710 0.1680 0.1613 0.1470 0.1321 0.1180
m = 17 0.1715 0.1691 0.1632 0.1503 0.1364 0.1229
m = 19 0.1720 0.1698 0.1645 0.1526 0.1394 0.1265
m = 21 0.1723 0.1704 0.1655 0.1541 0.1417 0.1292
m = 23 0.1726 0.1708 0.1662 0.1553 0.1434 0.1313
m = 25 0.1728 0.1712 0.1667 0.1563 0.1448 0.1330
m = 30 0.1731 0.1718 0.1677 0.1579 0.1469 0.1361
Analogously, with larger investments in the risky asset (i.e., higher multiplier and/or
lower floor), the volatility also increases.
12.3.3. Shortfall Probability of CPPI Strategies

Definition 12.22. For a given CPPI strategy according to Algorithm 12.17 with param-
eters f and m, the shortfall probability SP(f, m) and the expected shortfall ES(f, m)
are defined as
SP(f, m) := P[VT ≤ LT ] = P[VT ≤ Vmin ],

ES(f, m) := E[VT − LT | VT ≤ LT ].
The corresponding stopping time τ := inf{t | Vt ≤ Lt } is called shortfall time. In case

no shortfall is experienced by the CPPI strategy, we have τ = ∞. We say that the CPPI
strategy has reached the absorbing state if Vt ≤ Lt , as from then onwards the strategy
is fully invested in the zero bond.
Tables 12.5 and 12.6 illustrate the interrelation of the shortfall probability and the
expected shortfall with the multiplier m and the floor f for a fixed risky asset (the
naïve one).
As expected, it can be observed that the shortfall probability increases with increas-
ing multiplier m. The floor influences the shortfall probability in a similar way: the
Table 12.5 Shortfall Probability of the Standard CPPI Strategy on the Naïve Risky
f = 0.90 f = 0.925 f = 0.95 f = 0.975 f = 0.99 f = 1.00
m=1 0 0 0 0 0 0
m=9 0 0 0 0 0 0
m = 11 0 0.02% 0.02% 0.02% 0.02% 0.02%
m = 13 0.08% 0.16% 0.26% 0.28% 0.32% 0.38%
m = 15 0.48% 0.70% 1.14% 1.78% 2.08% 2.32%
m = 17 1.82% 2.62% 3.88% 5.62% 6.60% 7.32%
m = 19 3.80% 5.78% 8.30% 12.00% 14.22% 16.00%
m = 21 6.68% 10.10% 14.22% 20.12% 24.08% 27.20%
m = 23 9.16% 13.74% 19.62% 28.22% 34.06% 38.52%
m = 25 11.64% 17.56% 24.94% 35.44% 43.26% 48.54%
m = 30 15.86% 24.04% 33.42% 46.94% 56.54% 63.02%
Table 12.6 Expected Shortfall of the Standard CPPI Strategy on the Naïve Risky
f = 0.90 f = 0.925 f = 0.95 f = 0.975 f = 0.99 f = 1.00
m=1 — — — — — —
m=9 — — — — — —
m = 11 — −0.0015 −0.0011 −0.0008 −0.0006 −0.0004
m = 13 −0.0008 −0.0030 −0.0022 −0.0016 −0.0012 −0.0022
m = 15 −0.0030 −0.0026 −0.0029 −0.0022 −0.0018 −0.0018
m = 17 −0.0025 −0.0022 −0.0024 −0.0022 −0.0018 −0.0015
m = 19 −0.0026 −0.0023 −0.0023 −0.0021 −0.0019 −0.0017
m = 21 −0.0026 −0.0023 −0.0023 −0.0021 −0.0020 −0.0019
m = 23 −0.0027 −0.0025 −0.0025 −0.0022 −0.0022 −0.0021
m = 25 −0.0028 −0.0027 −0.0027 −0.0024 −0.0025 −0.0023
m = 30 −0.0034 −0.0033 −0.0034 −0.0031 −0.0031 −0.0031
closer the floor to the initial wealth, the higher the shortfall probability. Further, the
expected shortfall remains approximately constant.
Remark 12.23. In practice, the multiplier m is deduced from the consideration of the
shortfall risk by a Monte Carlo simulation. The multiplier is chosen as large as pos-
sible to obtain a sufficient average investment return, while keeping a pre-determined
level of shortfall risk, i.e., low shortfall probability and low expected shortfall. For this
purpose, practitioners usually run simulation studies like the above to obtain a suit-
able multiplier. It should be noted that there are analytical approximations available
(see [27]), which link the multiplier to the volatility or percentiles of the one-period
return distribution. However, these approximations are only valid if Et = mBt , i.e., for
sufficiently small multipliers, and do not longer hold if Et is capped at Vt . In the latter
case, the approximation largely overstates the potential shortfall risk. Therefore, one
has to rely on Monte Carlo simulations.
12.3.4. Improving CPPI Strategies

Thus far, we have only used the naïve portfolio as risky asset. We already pointed out
that it should be possible to improve the performance of the CPPI strategy in the same
manner as the one-period portfolio performance can be improved by mean–variance
optimization. If we replace the naïve portfolio (characterized by the weekly parameters
µX = 0.16%, σX = 2.1%) by a mean–variance efficient portfolio with the same level
of risk (volatility) and higher average return (µY = 0.19%, σY = 2.1%), we expect an
improved average performance of the CPPI strategy and along with this a decreased
shortfall risk. This choice of the mean–variance efficient portfolio is illustrated in
Fig. 12.3.
As we see in Fig. 12.4, the average return of the CPPI strategy is indeed signif-
icantly increasing, while the risk stays nearly at the same level. Therefore, we can
0.11
0.105
0.1
0.095
0.09
Efficient frontier
Min. variance portfolio
0.085
Naive portfolio
Max. sharpe ratio portfolio
Naive portfolio efficient
0.08
0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22
Volatility (p.a.)
Figure 12.3 Markowitz efficient frontier including mean–variance efficient portfolio.

0.35
Exp. return naive
Exp. return efficient
0.3 Vol naive
Vol efficient
Shortfall prob. naive
0.25 Shortfall prob. efficient
0.2
0.15
0.1
0.05
0
5 10 15 20 25 30
Multiplier (m)
Figure 12.4 Improvement of the standard CPPI (f = 0.95) by replacing the naïve portfolio
with an efficient one.
conclude that mean–variance optimization can actually improve the performance of

CPPI strategies.
Since mean–variance optimization offers a complete efficient frontier, it is not
clear which portfolio thereon should be chosen as risky asset. It is further not obvious
how the performance of CPPI strategies on these different risky assets should be
compared. We have therefore picked a rather practical approach toward this question.
For each CPPI strategy, we choose the largest multiplier — cf. Table 12.7 — such that
the shortfall risk is still smaller than 1% and compare their average performance and
standard deviation, see Tables 12.8 and 12.9. As risky assets, we haven chosen the
Table 12.7 Multipliers for Selected CPPI Strategies for Different

Floors f , Such that the Shortfall Probability Is Below 1%.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI naïve 14.50 14.00 13.75 13.75

CPPI naïve efficient 14.50 14.00 14.00 13.75
CPPI minvar 16.75 16.00 16.00 15.75
CPPI maxsharpe 16.00 15.50 15.25 15.25
Table 12.8 Expected Return of Selected CPPI Strategies for Different Floors
f and multiplier m, Such that the Shortfall Probability is Below 1%.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI naïve 0.0968 0.0850 0.0754 0.0676

CPPI minvar 0.1016 0.0900 0.0805 0.0724
CPPI maxsharpe 0.1085 0.0960 0.0854 0.0768
Table 12.9 Standard Deviation of Selected CPPI Strategies for Different

Floors f and Multiplier m, Such that the Shortfall Probability is Below 1%.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI naïve 0.1607 0.1448 0.1285 0.1141

CPPI minvar 0.1473 0.1359 0.1234 0.1107
CPPI maxsharpe 0.1555 0.1437 0.1301 0.1172
already introduced canonical candidates from the previous section — the minimum
variance portfolio, the maximum Sharpe ratio portfolio, the naïve portfolio, and its
mean–variance efficient replacement. It can be observed that the three mean–variance
optimal portfolios clearly dominate the inefficient naïve portfolio, both in terms of
expected return and Sharpe ratio. Comparing the efficient portfolios with each other is
not as easy. Taking the point of view of the asset manager, the risk of the asset manager
is clearly the cost of shortfall. These costs are roughly given by the product of shortfall
probability and expected shortfall. With shortfall probability below 1% and expected
shortfall roughly equal to 30 basis points, these costs are below one basis point. On the
other hand, as the asset manager wants to offer a strategy with a high expected return,
the maximum Sharpe ratio portfolio is clearly the best choice. This portfolio offers
a similar return as the efficient version of the naïve portfolio, but possesses smaller
standard deviation, and should hence be preferred.
Remark 12.24. Although the above analysis looks very promising, a few details
should not be overlooked.
• The CPPI strategy needs to be implemented in the simulation framework as close as
possible to the real-world setup, as distinct features of such strategies may influence
the results of simulation studies. Among these are for example trading filters (mainly
directly linked to the traded lots ϕt ), fees (usually depending on Vt ), slippage
effects (depending on the traded volume vt ), ratchets, allowance for short positions,
additional risks from overlay management, planned cash injections, etc.
• The joint distribution of the zero bond and the risky asset has to be modeled rather
exactly. Especially the tail behavior plays a major role in the quantification of the
shortfall risk, whereas the estimation of the expected return is important for the
communication of the investment target return.
• The choice of the composition of the risky asset and thus the multiplier m are
subject to the same estimation risk. If the parameters of the return distribution are
uncertain, it is well known that the mean–variance efficient portfolios have a rather
poor performance (see next section). In this case, the originally valid idea of using
optimized portfolios may revert into the contrary.
Unfortunately, while the first point can be covered with sufficient accuracy, the esti-
mation of both the distribution and the distribution parameters are always subject to
uncertainty. As shown in [4], [7] or [16] mean–variance efficient portfolios strongly
depend on the input data. Due to the inherent uncertainty in the estimates, the resulting
portfolios as well as their estimated returns and volatilities are thus not reliable, see
for example [23].
Thus, a natural question in this context is: how much can the results differ in the
presence of estimation risk? As already mentioned in the introduction, we focus on
the estimation risk for the parameters and assume for simplicity that the distribution
family itself is known.
Remark 12.25. Bertrand and Prigent have considered a possible estimation of the
multiplier by extreme value theory in [3]. Although this research is probably the closest
one to this study, its line of thinking is solely concerned with shortfall risk. They
concentrate on the choice of the multiplier by looking at the corresponding percentiles
of the one-period return distributions by extreme value theory. Our study goes into a
different direction, as we simultaneously cover shortfall risk and expected return, but
do so via parameter uncertainty.
12.3.5. CPPI Strategies Under Estimation Risk

For the illustration of estimation risk, we consider a very simple example. We still
assume that the asset returns follow the originally specified distribution, however,
the asset manager has to estimate these parameters, for example from an historical
sample. Therefore, the asset manager has to work with estimates µ̂ and ˆ instead
of the original parameters µ and . We have chosen a typical example of µ̂ and
ˆ which represents all stylized facts known about estimation risk. In Fig. 12.5, the
,
solid line represents the efficient frontier based on the original parameters µ and ,
which are unknown to the investor. Results (see Table 12.10) corresponding to port-
folios based on this efficient frontier will be tagged optimal or original. The dashed
line in Fig. 12.5 represents the expectation of the asset manager, i.e., the efficient
efficient frontier based on original parameters

0.18
efficient frontier based on random parameters
random parameters only for optimization
minimum variance portfolio
0.16 maximum Sharpe ratio portfolio
0.14
0.12
0.1
0.08
0.06
0.1 0.12 0.14 0.16 0.18 0.2 0.22
Volatility (p.a.)
Figure 12.5 Original and estimated efficient frontiers.
frontier based on the random parameters µ̂ and . ˆ This situation will lead to the
numbers tagged perceived or random. Finally, the dotted line is the efficient fron-
tier the investor will actually obtain, i.e., optimizing the portfolios according to the
expected parameters µ̂ and ,ˆ but realizing the risk–return profile with the true market
parameters µ and . Table 12.10 summarizes the return and volatility characteris-
tics of the minimum variance and the maximum Sharpe ratio portfolios on the three
frontiers.
Therefore, in Fig. 12.5, two kinds of estimation risk can be noticed. First, the
asset allocation is calculated based on µ̂ and ˆ and thus return µ̂X and volatil-
ity σ̂X are obtained based on the optimized allocation. As shown in [17], these are
Table 12.10 Illustration of the Estimation Risk of the Minimum

Variance Portfolio and the Maximum Sharpe Ratio Portfolio.
Actual Perceived Optimal
Return minimum variance 0.0800 0.0823 0.0836

Return maximum sharpe ratio 0.0733 0.1147 0.0924
Volatility minimum variance 0.1355 0.1175 0.1336
Volatility sharpe ratio 0.1539 0.1323 0.1393
biased estimators compared to the optimal values µX and σX and on average it holds
that µ̂X > µX and σ̂X < σX . This also gets obvious from Fig. 12.5. Further, as
the wrong asset allocation is implemented, an inferior portfolio performance can be
achieved in the market, see also [17] for more details. This can again be observed
in Fig. 12.5, where the true original frontier dominates the portfolios calculated by
the asset manager. Although we have picked only one representative toy example,
in [17], it is shown that this represents the average situation. Taking the estimates µ̂
and ˆ together with the corresponding risky asset compositions, the simulation of
the standard CPPI can be performed as usual Table 12.11. From this, optimal mul-
tipliers are obtained for both portfolios. The multipliers have been chosen in such
a way that the corresponding shortfall probabilities are roughly 1%. This choice of
multipliers yields the following perceived performance and standard deviation, see
Tables 12.12 and 12.13. Based on these multipliers and the wrong allocation, we run
the simulation again, this time with the true market parameters. Then, instead of the
above figures, we obtain the corresponding actual figures, see Tables 12.14–12.16.
Table 12.11 Multipliers m of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 19.50 18.75 18.25 18.00

CPPI maxsharpe 17.50 16.50 16.25 16.00
Table 12.12 Perceived Expected Return of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.1048 0.0941 0.0847 0.0766

CPPI maxsharpe 0.1358 0.1205 0.1075 0.0960
Table 12.13 Perceived Standard Deviation of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.1331 0.1265 0.1163 0.1057

CPPI maxsharpe 0.1574 0.1496 0.1384 0.1264
Table 12.14 Actual Shortfall Probabilities of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.0409 0.0446 0.0447 0.0449

CPPI maxsharpe 0.0631 0.0584 0.0595 0.0568
Table 12.15 Actual Expected Return of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.0978 0.0868 0.0778 0.0704

CPPI maxsharpe 0.0880 0.0774 0.0691 0.0625
Table 12.16 Actual Standard Deviation of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.1493 0.1391 0.1267 0.1145

CPPI maxsharpe 0.1608 0.1456 0.1304 0.1163
The most noteworthy differences are both in the expected performance and in the
shortfall probability. Although the shortfall probability was believed to be below 1%,
it significantly increased to about 5%. This is not only worrying from the point
of view of the asset manager, who actually faces higher costs to cover shortfall,
but as well from the perspective of the client, who has a much higher probability
of ending up in the absorbing state than intended. Even more troublesome is the
expected return of the formerly superior maximum Sharpe ratio portfolio. Due to
the error maximization, the expected return of this portfolio turned out to be unre-
liable and the gap to the perceived performance is significant. In contrast to this,
the minimum variance portfolio shows a rather stable behavior in terms of expected
return.
Based on this toy example, it is already obvious that a more prudent choice of
multiplier and a consideration of the estimation risk in the composition of the risky asset
is absolutely necessary. Therefore, in the next section, we will introduce a framework
which not only provides more robust asset allocations, but at the same time gives
prudent estimates of risk and return which can be used in the composition of the CPPI
strategy.
12.4. ROBUST MEAN–VARIANCE OPTIMIZATION

AND IMPROVED CPPI STRATEGIES
In the last years, several attempts have been made to improve the estimation of
mean–variance efficient portfolios. A meanwhile pretty well-known way to robus-
tify portfolios is the resampling technique introduced and made popular by Michaud,
see [23], based on concepts as, e.g., given in [16]. Another rather popular approach is
the usage of robust estimators, as, e.g., investigated in [18], [19] or [26]. The third line of
thinking is based on the robust counterpart idea introduced by Ben-Tal and Nemirovski,
see [2]. Several authors have considered instances varying from theoretical to practical
settings, see e.g. [6], [13], [20], [31] and [33].
12.4.1. Robust Mean–Variance Analysis

Depending on the availability of historical data (length of sample period, frequency of
sampling, etc.) and the utilized estimation routine for µ and , the resulting estimates,
ˆ can vary, i.e., they are uncertain. Now, instead of only considering
denoted by µ̂ and ,
these uncertain point estimates, an entire range of possible parameter realizations —
a (convex and compact) uncertainty set U — is taken into account and the portfolio is
optimized with respect to the worst outcome within U.
Definition 12.26. The robust counterparts to problems (Pλ ) are given by

√
min max (1 − λ) w Cw − λw r (RPλ )
w∈W (r,C)∈U
with U being the (joint) uncertainty set for the unknown parameters (µ, ). In analogy
to the classical setting, the optimal solution of (RPλ ) will be denoted by w∗rob (λ).
Remark 12.27. It can be shown that the resulting robust portfolios are unique for
0 ≤ λ < 1, see [29], Proposition 5.2, for general convex and compact uncertainty
sets U.
Most applications of the robust counterpart approach are based on statistical confi-
dence sets around the corresponding point estimates, see [2], [6], [13], [20], [22],
or [32]. In general, the most intuitive confidence sets coming from statistics are confi-
dence ellipsoids, as for example nicely motivated in [22], Sec. 2.4.3. Typically, the
center of the ellipsoid is determined as the estimated value of the point estimate
and its shape is described using an according estimate for the estimator’s covariance
matrix. In addition, the size of the uncertainty set is calculated from an appropriate
percentile to achieve the desired level of confidence. Alternatively, several different
expert opinions (or likewise different estimators) can be used to form an uncertainty
set, see [20]. In most practical instances, the robustification is focused on the uncer-
tainty in the mean, while the covariance matrix is assumed to be known with certainty,
which is well supported by a number of theoretical results on the impact of both
uncertainties.
12.4.2. Uncertainty Sets Via Expert Opinions or Related Estimators

In the following, we assume that we have several different estimators available for
the uncertain parameter, for example from experts’ forecasts. Alternatively, different
estimators may be derived by different estimation routines. The standard maximum
likelihood estimator, although very popular, is not the only unbiased consistent esti-
mator, which may be used for elliptical distributions. In fact, there exist several other
common estimators for the mean of an elliptical distribution used by practitioners.
For example one could consider the following four consistent estimators for the return
besides the maximum likelihood estimator:
• The median, i.e., the 50% quantile of the data sample

• The average of the 25% and the 75% quantile
as well as two robust estimators,
• The Huber estimator, see [14]

• The trimmed mean, which is defined as the maximum likelihood estimator of the
sample reduced by the α-percent smallest and largest values (i.e., the outliers)
As shown in [30], ellipsoidal uncertainty sets have nicer theoretical properties — in

terms of smoothing and robustness properties — than polyhedral ones. Thus, instead
of using the (polyhedral) convex hull
ˆ
U = conv(r1 , . . . , r5 ) × {}

5
5
ˆ
= r r = αi ri , with αi ≥ 0, αi = 1 × {}

i=1 i=1
of these five estimators, denoted by r1 , . . . , r5 , to define the uncertainty set U, we

prefer to use the ellipsoid
ˆ
U = {r | (r − r̄) C̄−1 (r − r̄) ≤ δ2 } × {},
where r̄ is the average of the five different estimates and C̄ = D2 with D being the
diagonal matrix with the standard deviations of the individual estimates from their
common average. In this case, the size δ of the ellipsoid is determined such that
all estimates are contained within. In other words, the uncertainty set for the return
is given by the smallest ellipsoid centered at the common average of the various
estimators and shaped by their standard deviations. Combining everything and solving
the inner maximization problem in (RPλ ) analytically, the robust portfolios w∗rob (λ)
can be obtained by solving

min (1 − λ) w w ˆ + λ[δ w C̄w − w r̄].
w∈W
This means that on top of the investment risk, i.e., risk from the stochastic asset returns,
an additional penalty for estimation risk is considered in the optimization. This penalty
grows linearly with the uncertainty in the estimators, i.e., with δ, as well as linearly
in the importance λ of the return term. Although this is a very appealing approach
in practical settings, for the aim of the study, it is easier to work with an alternative
specification of uncertainty sets.
12.4.3. Uncertainty Sets Via Confidence Sets

As already mentioned, the most prominent choice for the uncertainty set lies in the
traditional confidence ellipsoid around the maximum likelihood estimator µ̂, i.e.,
U1 := {r | (r − µ̂) ˆ
ˆ −1 (r − µ̂) ≤ δ2 } × {}, (12.6)
where δ is chosen appropriately to the target confidence level of the uncertainty set.
Again, no uncertainty of the covariance matrix is considered.
A more advanced version of the confidence set also considers the uncertainty of
the covariance matrix. In the latter case, applying similar ideas as in [22], it is possible
to show (see [32]) that the natural confidence ellipsoid around the joint maximum
ˆ approximately has the following form
likelihood estimator for both (µ̂, )
−1
U2 = (r, C) | (r − µ̂) ˆ −1 (r − µ̂) + 2 ·
ˆ 2 (C − ) ˆ − 12 2 ≤ δ2 .
ˆ (12.7)
tr
Using any one of the above uncertainty sets a surprising result can be proved by a close
investigation of the necessary and sufficient first-order optimality conditions (i.e., the
KKT conditions), see [28] or [32]: the robust efficient frontier is exactly the classical
efficient frontier up to a certain risk (i.e., volatility) level depending on the choice
of the parameter δ. In other words, the original classical efficient frontier is robust
in itself, as long as we do not move too far to the right. This can be interpreted as
if robustification is able to identify the unreliable upper part of the efficient frontier
which is cut off. The following theorems, taken from [32] formally state the described
result. Let
δ
H(θ) = 1 − θ + θ √ ,
S
 

2 κ
K(θ) = max (1 − θ) 1 + δ (1 − κ) + θδ ,
κ∈[0,1] S−1 S
where in this context S denotes the number of observations used for the point estima-
tion. Although K is given in terms of an optimization problem, it is computed rather
easily by any one-dimensional optimization routine.
Theorem 12.28. Let U = U1 as in (12.6) and let θ ∈ [0, 1]. Then the optimal solution
w∗rob (θ) of (RPθ ) equals the optimal solution w∗cl (λ) of the original problem (Pλ ) for
λ = H (θ) = θ/(θ + H(θ)).
Theorem 12.29. Let U = U2 as in (12.7) and let θ ∈ [0, 1]. Then the optimal solution
w∗rob (θ) of (RPθ ) equals the optimal solution w∗cl (λ) of the original problem (Pλ ) for
λ = K (θ) = θ/(θ + K(θ)).
Remark 12.30. The most important consequences of these theorems are
• The cut off risk level for the robust frontier can be determined by solving the classical
formulation with
1
λmax = H (1) = K (1) = √ < 1.
1 + δ/ S
The optimal portfolio w∗cl (λmax ) then determines the cut off risk level as

σmax = w∗cl (λmax )w ˆ ∗cl (λmax ).
• Considering the special point θ = 0, i.e., the (robust) minimum variance portfolio,
the corresponding λ is also zero, i.e., the minimum variance portfolio is already
robust in itself. For U1 the robust counterpart reduces to

min ww,ˆ
w∈W
which is obvious as the minimum variance portfolio does not depend on the uncertain
parameter µ. If uncertainty of the covariance matrix is considered, then the robust
counterpart reduces to

2
ˆ
min K(0) w w = min 1 + δ
ˆ
w w.
w∈W w∈W S−1
for the uncertainty set U2 . This means that the consideration of the uncertainty
of the covariance matrix is reflected in the factor K(0). Since this factor is larger
than 1, a higher volatility (i.e., a larger objective value) is expected for the minimum
variance portfolio in the robust setting. This increase in the risk can be interpreted
as a measure for estimation risk and can be incorporated to obtain an improved
estimation of the multiplier m.
• The results of both theorems hold true due to the fact that the matrices for measuring
the portfolio’s risk and for describing the shape of the uncertainty set U have the
same structure and hence the expressions for the risk and the penalty for estimation
risk can be combined. Otherwise we would end up as in the previous subsection,
where different penalty terms for estimation risk appear in the objective function.
The effect of such a robustification for an investor is that her position on the efficient
frontier moves to the left, toward the minimum variance portfolio. Hence, robustifi-
cation leads to more conservative portfolio choices that are nevertheless efficient —
simply with respect to a different trade-off parameter.
12.4.4. Usage and Implications for CPPI Strategies

The above robust optimization framework can now be used to improve the performance
of CPPI strategies under estimation risk. For this purpose, we suggest the following
methodology:
Algorithm 12.31. For a given robustification parameter δ and estimated parameters

µ̂ and ˆ based on S historical observations, we proceed in the following steps to
determine an appropriate allocation of the risky asset w together with a corresponding
multiplier m:
(1) Calculate the robust efficient frontier according to the previous section. Choose
an arbitrary portfolio w from the robust frontier, preferably the robust minimum
variance or the robust maximum Sharpe ratio portfolio.
(2) Determine the robustified parameters
1
µ̃ = µ̂ − δ √ ˆ
w, ˆ
˜ = K(0)2 · .
ˆ
S ww
(3) Run the CPPI strategy with the robustified parameters and fix the multiplier m as
usual, i.e., at an acceptable level of shortfall risk.
The choice K(0) is deduced from the fact that this factor appears in the robustified
version of the minimum variance problem and represents the penalty for the uncertainty
in . For all other portfolios, K(λ) is smaller and could be calculated, but for simplicity,
we use K(0) instead. The correction of the expected returns is motivated by the fact
that the worst-case return in the confidence set is given by µ̃, although this is a rather
pessimistic approach which may need some refinement.
If we apply Algorithm 12.31 to the previous setting for realistic choices of robusti-
fication parameters, δ = 1 and S = 52, we obtain µ̃ and K(0) as in Table 12.17. It can
be observed that the robustified return µ̃ is overly pessimistic and cannot be used to
estimate the expected performance of the portfolios or the CPPI strategy. Nevertheless,
it is still well suited for the determination of the multiplier m, as for this purpose, an
adverse market setting leads to a conservative choice. Further, the volatility plays the
major role in the setting of the multiplier anyway.
Table 12.17 Period Returns for the Tradeable Assets.

µ 0.15% 0.26% 0.18% 0.26% 0.24% 0.22%
µ̂ 0.16% 0.17% 0.33% 0.16% 0.24% 0.21%
µ̃ −0.13% −0.17% 0.05% −0.13% −0.09% −0.07%
K(0) 1.0945
Table 12.18 Multipliers m of Robust CPPI Strategies Based on Robus-

tified Parameters.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI robust minvar 16.25 15.75 15.75 15.50

CPPI robust maxsharpe 15.75 15.25 15.25 15.00
Using the robustified allocations for the risky assets and running the CPPI simu-
lation with the robustified parameters, we get the following multipliers, illustrated in
Table 12.18. The multiplier was again chosen in such a way that the corresponding
shortfall probability is below 1%. Comparing these multipliers to those in Table 12.11,
we see that the above multipliers are significantly smaller than those derived from the
estimated, but non-robustified, parameters.
Remark 12.32. From the illustration of the robust frontier, see Fig. 12.6, it can be
noticed that the robust frontier is usually rather short. This means that large deviations
from the minimum variance portfolios are usually not possible within the robust frame-
work. Therefore, we do not expect large differences between the (robust) minimum
variance and the robust maximum Sharpe ratio portfolio.
0.11
0.105
0.1
0.095
0.09
0.085
Efficient frontier
Robust efficient frontier
0.08
0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0.21 0.22
Volatility (p.a.)
Figure 12.6 Illustration of the classical and the robust efficient frontier.
12.4.5. CPPIs with Robust Asset Allocations

After we have calculated both the (robustified) risky allocations and the corresponding
multipliers, the CPPI strategy can be simulated as usual with the true market param-
eters. From this simulation, we obtain the actual shortfall probabilities and the actual
average performance of the CPPI strategy. According to our expectation, the robustifi-
cation, which resulted in a decrease of the corresponding multiplier as well as a more
prudent asset allocation, yields very promising results on shortfall probabilities. In
contrast to the significantly increased probabilities for the non-robustified allocations
we now have comparable shortfall probabilities as intended, see Table 12.19.
Before comparing actual expected returns of selected (robust) CPPI strategies,
we recall in the following Tables 12.20 and 12.21 the optimal and perceived expected
returns of non-robustified CPPI strategies as already given in Tables 12.8 and 12.12.
Now finally, the actual expected returns of the considered non-robust and robust CPPI
strategies are summarized in Table 12.22. It can be observed that the two CPPI strate-
gies based on minimum variance portfolios lead to almost identical expected returns.
Eventually, the almost identical returns are not surprising since the allocations for the
risky asset used in the respective CPPI strategies are identical, only the multipliers dif-
fer. Nevertheless, this difference in the multiplier is responsible for a rather improved
Table 12.19 Actual Shortfall Probabilities of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.0409 0.0446 0.0447 0.0449

CPPI maxsharpe 0.0631 0.0584 0.0595 0.0568
Table 12.20 Optimal Expected Return of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.1016 0.0900 0.0805 0.0724

CPPI maxsharpe 0.1085 0.0960 0.0854 0.0768
Table 12.21 Perceived Expected Return of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.1048 0.0941 0.0847 0.0766

CPPI maxsharpe 0.1358 0.1205 0.1075 0.0960
Table 12.22 Actual Expected Return of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.0978 0.0868 0.0778 0.0704

CPPI maxsharpe 0.0880 0.0774 0.0691 0.0625
Table 12.23 Actual Standard Deviation of Selected CPPI Strategies.
f = 0.95 f = 0.975 f = 0.99 f = 1.00
CPPI minvar 0.1493 0.1391 0.1267 0.1145

CPPI maxsharpe 0.1608 0.1456 0.1304 0.1163
shortfall probability for the robust minimum variance portfolio compared to the non-
robust one. In case of the CPPI strategies based on maximum Sharpe ratio portfolios,
the expected returns of the robust versions are significantly higher compared to the
non-robustified risky asset allocations and much closer to the optimal ones. However,
even with robustification, CPPI on maximum Sharpe ratio portfolios actually can-
not beat those on the minimum variance portfolio, which in turn still beats the naïve
strategy. This means that portfolio optimization still adds value to the investment
process, but that estimation risks have to be taken very seriously. For completeness,
Table 12.23 contains the actual standard deviations of selected non-robust and robust
CPPI strategies. As expected, all robust versions have a lower standard deviation than
their corresponding non-robust strategy.
12.5. CONCLUSION
In this study, we have shown that under full information CPPI strategies should rely on
mean–variance efficient portfolios as risky assets. Based on Monte Carlo simulations,
suitable multipliers can be found. We have demonstrated that estimation risk may
have a significant impact on the performance of the CPPI strategy. A potential remedy
by robust mean–variance optimal portfolios seems to be beneficial for the overall
performance of the strategy, especially for the shortfall risk of the asset manager and
the average return. Nevertheless, our results also show that optimization beyond the
minimum variance portfolio is heavily influenced by estimation risk. Based on these
preliminary results, it can be concluded that a more detailed and thorough analysis
needs to be carried out to investigate estimation risk and its cures in a broader context.
Acknowledgments
The authors want to express their gratitude to the editors for the opportunity to make this
contribution. Further, the second author appreciates the hospitality at the HVB Insti-
tute for Mathematical Finance, TU München, especially the inspiring annual research
seminars which fostered part of the research on robust allocations.
Disclaimer
The views expressed in this article are the authors’ personal opinions and should not be
construed as being endorsed by MEAG MUNICH ERGO AssetManagement GmbH
or Hypo Real Estate Holding AG.
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13
ROBUST ASSET ALLOCATION
UNDER MODEL RISK
PAULINE BARRIEU∗ and SANDRINE TOBELEM†

Department of Statistics, London School of Economics,
Houghton Street, London WC2A 2AE England, UK
∗
p.m.barrieu@lse.ac.uk
†
s.e.tobelem@lse.ac.uk
In this chapter, we propose a robust asset allocation methodology, when there is some
ambiguity concerning the distribution of asset returns. The investor considers several
prior models for the assets distribution and displays an ambiguity aversion against
them. We have developed a two-step ambiguity robust methodology that offers the
advantage to be more tractable and easier to implement than the various approaches
proposed in the literature. This methodology decomposes the ambiguity aversion into
a model-specific ambiguity aversion as well as relative ambiguity aversion for each
model across the set of different priors. The optimal solutions inferred by each prior are
transformed through a generic absolute ambiguity function ψ. Then, the transformed
solutions are mixed together through a measure π that reflects the relative ambiguity
aversion of the investor for the different priors considered. This methodology is then
illustrated through the study of an empirical example on European data.
327
328 Barrieu and Tobelem
13.1. BACKGROUND
In this chapter, we aim at characterizing and constructing a methodology for robust

portfolio allocation under model risk, i.e., when the investors consider different models
for asset returns distribution to take their allocation decision.
More precisely, let us consider a financial market with N risky assets and a risk-
free asset. An investor wants to allocate her wealth among these assets, by choosing
φ ≡ (φ0 , . . . , φN ), the vector of weights for the risk-free asset and the N risky assets.
The standard framework for investment decision making has been developed by
Markowitz in [1], where there is no model uncertainty. The optimal portfolio allocation
is obtained as the solution of the following optimization program:
φ∗ ≡ argmax EP [u(Xφ , λ)], (13.1)
φ
where u is a Von-Neumann Morgenstern utility function characterizing the investor’s

preferences and parametrized by the risk aversion parameter λ, and Xφ stands for the
terminal value of the portfolio at a given time horizon. In this setting, P stands for
the only prior (or model for the distribution of the assets returns) the investor has, and
is known without ambiguity. Hence, the risk of the investor is perfectly quantifiable
through the know-ledge of the distribution P.
The agent may also consider different models Q in a finite set of possible models
Q. In this case, the investment problem is modified according to the subjective view
π(Q) of the investor on each model Q. More precisely, π(Q) represents the subjective
likelihood of the model Q for the investor. The investor operates a linear blending of
the different models, weighted by their subjective probability π(Q) to be the “real”
model. Under each model, the investor considers the objective-expected utility of her
future wealth. Across all priors, the investor considers the subjective-expected value
of the expected utilities under the different models. Such a framework is referred to
as Subjective Expected Utility (SEU) and was first introduced by Savage in [2]. The
optimal portfolio allocation is then obtained as

φ∗ ≡ argmax EQ [u(Xφ , λ)]π(Q). (13.2)
φ
Q∈Q
Note that in this framework, even if the agent has several priors as reference, he/she
does not show any aversion toward the co-existence of different models to take her
decision. He or she is neutral toward model uncertainty as there exists no ambiguity
about the set of models considered and their likelihood to occur.
However, as shown by Ellsberg in [3], the decision makers show a more averse
behavior when betting on events for which outcomes are ambiguous (i.e., when there
is also some uncertainty regarding the underlying model) than when betting on events
for which the outcomes are only risky (i.e., the underlying model is well known).
Robust Asset Allocation Under Model Risk 329
A financial illustration of the Ellsberg paradox is the risk premium paradox: investors
tend to invest more in their local market even though the expected return is lower than
for foreign markets, the reason being that the investors add an ambiguity premium
to risky assets (investors prefer investing in assets located in their geographical zone,
because they can better apprehend their return distribution).
For this reason, the SEU framework fails to take into account this additional
source of aversion of investors. Various approaches have been developed in the liter-
ature to take into account this aversion toward model uncertainty in the investment
decision process. Among them, Gilboa and Schmeidler in [4] proposed a min–max
approach leading to a very conservative decision rule based upon the worst case
model. More recently, Klibanoff et al. in [5] introduced a generalized model. They
consider an increasing, concave transformation function characterizing the investor
ambiguity aversion through a parameter γ. The optimal weights vector is then deter-
mined as

φ∗ ≡ argmax {EQ [u(Xφ , λ)], γ}π(Q). (13.3)
φ
Q∈Q
The main feature of this model is that it unifies all the previous approaches accounting
for model ambiguity. However, this theoretical approach can be very challenging to
implement in practice for different reasons, including the calibration of the various
parameters. Indeed, no distinction is made between specific ambiguity aversion for a
given model (“How good is this specific model to represent the reality?”) and general
ambiguity aversion for the whole class of models (“How much can all the models
explain the reality?”). Moreover, solving explicitly Program (13.3) can be extremely
difficult, even numerically, especially in the multi-dimensional case or when adding
some constraints on the portfolio allocation. Note that Klibanoff et al. only give a
simple numerical example for a portfolio with three assets in their paper [5], whereas
practitioners often consider portfolios with hundreds of assets. We have compared their
example to our methodology in [6] and we also provide a more complex theoretical
example that can be solved in close form if using our methodology. Finally, such an
approach lacks some flexibility in the sense that if the investor considers a new model,
he or she has to re-compute the program entirely. To overcome those limitations, we
propose a robust, general framework for decision making under uncertainty. We are
not aiming at finding the optimal solution for a given criterion but more at finding a
robust solution.
13.2. A ROBUST APPROACH TO MODEL RISK
We propose a new approach to model ambiguity that is altogether more flexible, easier
to compute, more robust and tractable than the methods proposed in the literature. This
Ambiguity Robust Adjustment (ARA) approach is independent of the set of models

considered, as well as of the choice criterion (i.e., the value function they consider to
determine their preferred asset allocation) to define the optimal portfolio under each
model Q ∈ Q, for Q a finite set of models.
More precisely, we proceed in two steps and introduce a distinction between two
types of ambiguity:
• Absolute ambiguity: this refers to the ambiguity the investor has for a given model.
We first solve the optimization problem assuming that the model considered is the
true model. We thus compute a distorted expected value of the deduced optimal
weights, transformed by an Absolute Ambiguity Robust Adjustment (AARA) func-
tion denoted ψ. Note that the absolute adjustment is made on the solution and not
on the choice criterion. This allows us for some additional flexibility in the use of
each model.
• Relative ambiguity: this expresses the relative ambiguity the investor has among his
or her different models: in a second step, we aggregate the adjusted optimal weights
computed for each model through a RelativeAmbiguity RobustAdjustment (RARA)
function, denoted π.
Let us denote φQ ≡ argmaxφ EQ [u(Xφ , λ)]. Then the ARA portfolio allocation
φARA ≡ (φiARA )i∈{1,...,N} is obtained as

φiARA ≡ ψ{φQi , γ}π(Q), i ∈ {1, . . . , N} (13.4)
Q∈Q
N
and φ0ARA ≡ 1 − i=1 φiARA .
Due to its specific nature, the risk-free asset has no model risk associated with
it (its future value is known with certainty). Therefore, it plays a specific role in the
ambiguity-adjusted optimal asset allocation. It can be assimilated to a refuge value in
the following sense: the more the investor is averse to ambiguity, the more he or she
will invest in the risk-free asset. In this sense, as the “disinvested” part of the wealth
from the risky assets is transferred to the risk-free asset, the adjusted weight of the
risk-free asset corresponds to the amount of money the investor is reluctant to invest
in risky assets because of her aversion toward model risk.
We describe below the characteristics of the functions ψ and π.
13.2.1. The Absolute Ambiguity Robust Adjustment

The idea behind the AARA adjustment is that the investor, because she has doubts
about the optimal weights generated by a given model, wishes to scale down those
weights and especially the biggest absolute weights that could entail the biggest risks
in her portfolio.
The function ψ must satisfy some key properties to be consistent with the ratio-
nality of the investor:
• Definition of the function ψ: The investor treats the absolute ambiguity aversion
with the same type of transformation across all the different models (ψ is the same for
all the models). What distinguishes the absolute ambiguity aversion transformation
across the models is the specific ambiguity aversion parameter γ Q the investor
attributes to each model. As the optimal weights obtained for each model φQ are
bounded by 1, ψ(1, γ Q ) represents the maximum weight the investor will assign
to any asset after the AARA transformation. We note aQ ≡ ψ(1, γ Q ) and a ≡
maxQ∈Q aQ . Therefore, ψ is defined on the set of optimum model dependent weights
[−1; 1] × Q onto a set [−a; a] of transformed weights. Note that the investor can
set the value of aQ and deduce the value of γ Q depending on the explicit form he or
she chooses for ψ.

ψ : [−1; 1] × Q → [−a; a]
(13.5)
(φ, Q): → ψ(φQ , γ Q )
The following properties apply for the risky assets only, i.e., for i ∈ {1, . . . , N}.
• Monotonicity: One of the key characteristics of ψ is its monotonicity property.

ψ preserves the relative order of the optimal weights (φiQ )1≤i≤N deduced by a given
model Q, so that the relative preference of the investor toward the different risky
assets given a model Q is preserved through the transformation ψ.
• Convexity: The function ψ is concave on [0; 1] and convex on [−1; 0], so that
the function ψ reduces more the absolute largest weights given by the optimized
portfolios under each model considered. The convexity scale is parametrized through
the aversion coefficient γ Q : the bigger the aversion coefficient γ Q the more averse
the investor is to large weights inferred by Q. Also the convexity of ψ will depend
upon the investor ambiguity aversion toward the model Q ∈ Q considered. The
function ψ has an S-shape, as it penalizes more the largest positive and negative
weights (this is a particular case of the convexity property of ψ). For all assets i and
all models Q, we have |ψ(φiQ )| ≤ |φiQ |. The absolute ambiguity adjusted weights
are smaller than the optimal weights computed under a given model Q in absolute
terms.
Some additional properties can be considered depending on the assumption made on

the investor preferences and trading constraints.
• Symmetry: In a context where short selling is possible, there is no reason to differen-

tiate the long or short weights of the same magnitude in terms of ambiguity aversion.
The function ψ is then an odd function symmetric around zero. We can assume that a
long-short investor has the same aversion to positive or negative weights of the same
absolute value: ∀φi ∈ [−1; 1], ψ(−φi ) = −ψ(φi ). The AARA function penalizes
the scale of the optimal weights of a given model without discriminating between
negative and positive weights.
• Invariant point: There is no ambiguity aversion for a zero weight: ψ(0) = 0. If
the model Q assigns no weight on a given asset, the transformation ψ should not
modify the “neutrality” of the model Q toward this asset.
• Limit behavior: When the investor is infinitely averse to ambiguity, it will prevent
her from trading as he or she trusts none of his or her models, and therefore all
the portfolio weights should be defaulted to zero. On the contrary, if the investor
is neutral to ambiguity, the function ψ should leave the model-dependent weights
invariant.
We used a very similar function than the one applied by Klibanoff et al. to account
for ambiguity. The function ψ can be any classical S-Shape function, which has the
nice property of being concave (convex for negative values), symmetric, and mono-
tonic (similar attributes as for classical utility functions). What really characterizes the
function ψ is its ambiguity parameter γ that accounts for the concavity of the function
ψ and therefore the ambiguity aversion of the investor (Fig. 13.1).
Figure 13.1 ψ for different values of the ambiguity aversion parameter γ.

An example for the function ψ is



 1 − exp−γx

 , 0 ≤ x ≤ 1,
γ
ψ(x, γ) ≡ (13.6)

 expγx −1

 , −1 ≤ x ≤ 0.
γ
13.2.2. Relative Ambiguity Robust Adjustment

Once the optimal solutions have been computed for each prior Q and have been inde-
pendently adjusted for ambiguity aversion through the AARA function ψ, we need to
aggregate them across all priors in the set Q. The RARA function takes into account
the ambiguity aversion of each prior relative to the whole class of priors Q. Such an
adjustment is made through a mixture measure π. The RARA function π(Q) represents
the likelihood or degree of confidence the decision maker has for the adjusted result
given under Q when knowing all the adjusted results for all the other priors.
Therefore, π(Q) can be seen as a subjective weight given by the decision maker to
the adjusted solution for the model Q. π(Q) will therefore always be non-negative. If
the decision maker does not trust at all the prior Q relatively to the other priors, he or
she will simply set the weight to zero. If on the contrary he or she fully trusts the prior
Q, relatively to the other priors, then the weight for all the other priors will be zero.
The weight π(Q) is not necessarily one, since the agent may still believe that he or she
does not have the full understanding of the situation.
More formally we have
Definition 13.1 (RARA). The measure π : Q → [0; 1] is a Relative Ambiguity

Robust Adjustment (RARA) measure if:

∀ Q ∈ Q, 0 ≤ π(Q) ≤ 1 and π(Q) ≤ 1.
Q∈Q
After the transformation through the AARA function ψ and the RARA function π, the
ARA weight of any risky assets is defined as

∀i ∈ [1; N], φiARA = ψ(φiQ , γ Q )π(Q)
Q∈Q
and for the risk-free asset, the optimal weight is

N
φ0ARA = 1 − φiARA .
i=1
13.2.3. ARA Parametrization

The investor’s aversion to ambiguity is dynamic in the sense that, depending on the
period considered, he or she will be more or less confident about his or her models and
the overall set of models he or she considers. Therefore, we allow the function π and
the ambiguity aversion parameter γ to dynamically adapt and expand or contract the
total investment size whether the total ambiguity aversion decreases or increases over
time (the ambiguity parameter γ and the measure π can be re-parametrized at every
decision time). As pointed out by Epstein and Schneider [7], the ambiguity aversion of
an investor is not monotonically decreasing over time. Our RARA function allows the
investor to adjust her portfolio weights dynamically, depending on his or her overall
belief of how much his or her models can explain the true distribution P.
The approach is rather different from a classical Baysian updating approach, where
the investor learns more about the underlying model with any new information flowing
in the stock price returns. In a Baysian framework, the investor believes that once he
or she gets enough information, he or she will ultimately converge toward the true
model and therefore is gradually and monotonically more and more confident about
her model. Under model ambiguity however, this is not the case. The investor can
become more or less confident over time, in a non-monotonic way. He or she does
not assume that more information can systematically give his or her more confidence
about his or her model.
Many methods could be used in order to calibrate the different measures π(Q),
as well as the ambiguity aversion parameter γ Q for a given model Q. We propose a
simple empirical methodology that takes into account the relative historical perfor-
mance of the different models: First, we compute a number of performance measures
(the Sharpe, Sortino, Gain Loss or Win Lose ratios, as described in Sec. 13.4.2) on
the different models considered, evaluated over a given time window. The measure π
can then be computed as a weighted average of the performance measures, whereas
the ambiguity aversion parameter γ can be parametrized as the inverse of those per-
formance measures. More formally, we will consider the following parametrization
for our empirical example in Sec. 13.4: if we denote by PMpQ a given performance
measure p for a given model Q, we have
1
γQ ≡ (13.7)
PMpQ
and
PMpQ
π(Q) ≡ . (13.8)
P∈Q PMpP
Here we see that the measure π is relative, as it takes into account all the different models
performances, whereas γ is absolute, as it only considers the performance of a given
model. Note that the absolute ambiguity parameter is −γ rather than γ, according to the
shape of the function ψ given in Sec. 13.2.1. Both the relative ambiguity parameter π
and the absolute ambiguity parameter −γ are proportional to the performance measure
considered: the higher the performance measure, the higher the parameters. Note that
it is for the sake of simplicity that we chose to parametrize similarly π and γ, what
matters is that the absolute and relative ambiguity aversion be positively correlated
with the performance measure considered.
13.3. SOME DEFINITIONS RELATIVE

TO THE AMBIGUITY-ADJUSTED
ASSET ALLOCATION
To compare different asset allocations for different models, and also the impact of
the ambiguity aversion to the different weights assigned to each asset, we present in
the following section some properties and give some definitions. We also propose a
measure of distance between two different asset allocations that we will use to compare
different asset allocations in our empirical example developed in the last section. The
Ambiguity Robust Adjustment refers to the combine adjustment by the AARA to the
optimal weights independently computed for each prior and by the RARA performed
to combine those adjusted weights. These measures can be used to describe how to
measure the ambiguity aversion of an investor toward a model in general, and more
specifically toward a single asset.
For the following definitions, let φQ be the asset allocation conditional on model
Q ∈ Q and φARA be the ARA asset allocation.
Definition 13.2 (Portfolio Distance). Let us consider two models Q1 and Q2 in the
set of priors Q. We define the distance measure δ between the two models as

N
δ(φQ1 , φQ2 ) = |φiQ1 − φiQ2 |
i=0
δ(φQ1 , φQ2 ) represents the turnover value to rebalance the investor’s portfolio from the
asset allocation φQ1 to the asset allocation φQ2 .
Definition 13.3 (Weighted Ambiguity Adjustment). We denote by WAAi the ARA-

weighted ambiguity adjustment of an investor toward the asset i:

∀i ∈ [1, N], WAAi ≡ |φiARA − φiQ |π(Q)
Q∈Q
the ambiguity aversion of an investor toward an ambiguous asset i.

WAAi represents the average difference between the ARA weight for the asset i
and the optimal weights for the asset i under the different priors. For two ambiguous
assets Si and Sj ,j, i ∈ [1, N], if WAAi < WAAj , we say that the investor shows more
ambiguity aversion toward the asset j than toward the asset i.
Definition 13.4 (Absolute Ambiguity Adjustment). We define the value of the

Absolute Ambiguity Adjustment (AAA) of an investor toward the model Q as

N
AAA(Q) ≡ |φiQ − ψ(φiQ , γ Q )|.
i=1
AAA(Q) represents the theoretical turnover to rebalance the investor’s asset allocation
on the risky assets i = 1, . . . , N from the optimal weights obtained if the prior Q is
assumed to be equal to the unknown real model P to the Absolute Ambiguity Adjusted
portfolio, taking into account the investor absolute aversion against his or her prior Q.
We deduce that the total value of the investor’s Weighted Ambiguity Adjustment toward
all her priors is

N
AAA(Q) ≡ |φiQ − ψ(φiQ , γ Q )|π(Q).
Q∈Q i=1
Definition 13.5 (Relative Ambiguity Adjustment). We define the value of the Rel-
ative Ambiguity Adjustment (RAA) of an investor as

N
ARA Q
RAA(Q) ≡
φi − φi π(Q) ,
i=1 Q∈Q
which represents effectively the turnover between the Robust Ambiguity Portfolio and
the Subjective Expected Utility Portfolio (the SEU portfolio allocation is defined as:

φiSEU ≡ Q∈Q φiQ π(Q)).
13.4. EMPIRICAL TESTS
In this section, we detail the results of some tests we run to evaluate the performance
of ambiguity robust portfolios, compared to other classical optimized portfolios (we
consider optimized portfolios as well as other type of factor model portfolios, and
therefore we mainly focus on the ambiguity transformation and not on the initial
optimization under each prior). The tests were run on European assets. We collected
daily close prices from January 2000 to April 2008 (equivalent to 2167 business days).
Our set of securities is the set of Eurostoxx 600 constituents that were trading across the
whole period. For this empirical study, we consider a null risk-free rate (the cash is not
remunerated), as we consider a portfolio total return, as would be done for strategies
without benchmarks such as hedge funds or proprietary groups strategies. We assume
that our transactions costs, fees, and slippage correspond to three basis point of the daily
turnover of the strategy (i.e., the total costs and fees are assumed to be in percentage
three basis point of the daily turnover, for instance if the turnover of a strategy at a
given date is 50% and its return is 10 basis points, the costs and fees amount to 1.5
basis points return and therefore the startegy return for this day after cost is 8.5 basis
points). We run a back test on historical data when the investor re-balances daily her
portfolio by re-estimating the different models and re-setting her optimal investment
weights over an estimation window of 120 days (we choose a daily rebalancing, as
we consider daily returns for the asset time series). The performances of the different
strategies were then evaluated. We find that our Ambiguity Robust approach allows
the investor to achieve superior performance compared to that achieved by classically
optimized portfolios.
13.4.1. Portfolios Tested

We consider several models and their outcomes. More precisely, for each of them,
we computed portfolio weights using an estimation window, as if each one was the
true one. For the minimum-variance portfolio and the mean–variance portfolio, we
compute these weights according to the classical Markowitz framework. For the other
portfolios, we give some details below on how we compute the different weights. We
focus here on how the investor deals with her model ambiguity after the different model
portfolio weights have been computed.
We use an estimation window to estimate the following portfolio weights:
• The equally weighted portfolio (EW): gives an equal weight to all the risky assets.
We define the EW portfolio asset allocation as
1
∀i ∈ {1, . . . N} : φtEW,i = .
N
• The minimum variance portfolio (MN): is the fully invested Markowitz effi-
cient portfolio with minimum variance, obtained when the investor minimizes the
expected variance of the portfolio (i.e., minφ φ φ, where represents the covari-
ance matrix of the stock returns). The MN portfolio allocation is defined as
−1
t−w,t−1 1
φtMN =
1 −1
t−w,t−1 1
where t−w,t−1 is the empirical covariance matrix estimated over the window [t −
w, t − 1] and 1 is the N-vector of ones.
• The mean variance portfolio (MV): is the fully invested, maximum Sharpe, mean–
variance Markowitz efficient portfolio, obtained when the investor maximizes the
empirical quadratic expected utility (i.e., maxφ µφ −φ φ, where µ is the empirical
mean and the empirical covariance matrix of the stock returns, note that we
consider a risk aversion equal to 1). The MV allocation is defined as
−1
t−w,t−1 µt−w,t−1
φtMV = ,
1 −1
t−w,t−1 µt−w,t−1
where t−w,t−1 is the empirical covariance matrix estimated over the window [t −
w, t − 1] and µt−w,t−1 is the empirical vector of mean returns estimated over the
same window.
• The CAPM portfolio weights (CA): we base our CAPM portfolio on the Jensen
alphas. We estimate the CAPM betas over the estimation window. Consider-
M
ing rt−w:t−1 as the vector of the Eurostoxx 600 market returns over the period
[t − w, t − 1], the beta of the risky asset i is therefore estimated at time t as
i M
cov(rt−w:t−1 , rt−w:t−1 )
βti ≡ M
.
var(rt−w:t−1 )
We then compute the Jensen alpha as the difference between the observed return at
time t of the asset i and the beta-adjusted market return:
αit ≡ rti − βti rtM .
We then define the CAPM weights as the weighted average alphas across all the
risky assets considered:
αi
φtCA,i ≡ N t j
.
j=1 αt
• The CAPM uncertain portfolio (UC): we define the UCAPM weights as the CAPM
weights adjusted by the variance of the CAPM residuals:
αit
var(αi. )
φtUC,i ≡ j .
N αt
j=1 var(αj. )
We also consider three fundamental portfolios based on stock specific financial

ratios:
• The price earning portfolio (PE): we compute the relative price earning ratio
(PER) return of a stock among its sector peers and we give positive weights to the
lower PER stocks and negative weights to the higher ones.
• The cash flow portfolio (CF): we compute the relative cash flow ratio (CFR) return
of a stock among its sector peers and we give positive weights to the lower CFR
stocks and negative weights to the higher ones.
• The price to book portfolio (PB): we compute the relative price to book ratio
(PBR) return of a stock among its sector peers and we give positive weights to the
lower PBR stocks and negative weights to the higher ones.
More formally, we compute the relative financial ratio FR of the asset i among its
peers assets j in the sector S:
αFR,i,S
t ≡ µ(FR.,S
t ) − FRt ,
i
where µ(FR.,S t ) is the average of the given financial ratio among the assets in the
sector S. And therefore we get the following asset allocation, by scaling the alphas
per sector, so that the investor invests the same amount of money in each sector:
αFR,i
t
φtFR,i ≡ N FR,j,S
,
S
j=1 |αt |
where FR stands either for PE, CF, or PB and NS is the number of assets belonging
to sector S.
• The subjective expected utility portfolio (SEU): we define by π the vector of
Relative Ambiguity Aversion Weights given to the models considered. In the present

empirical example, we assume that Q∈Q π(Q) = 1, therefore the SEU portfolio
is defined as the different models weights weighted by π.

∀i ∈ {1, . . . , N} : φtSEU,i ≡ φQ,i π(Q).
Q∈Q
• The ambiguity robust portfolio (RA): finally, the optimal ambiguous portfolio
is defined as the different models weights adjusted by the Absolute Ambiguity
Adjustment ψ and weighted by the vector of Relative Ambiguity Aversion
Weights π:

∀i ∈ {1, . . . , N} : φtARA,i ≡ ψ(φQ,i , γ Q )π(Q).
Q∈Q
13.4.2. Performance Measures

In order to parametrize the absolute ambiguity parameter γ of the function ψ and the
relative ambiguity function π, to compute the SEU and RA portfolios, we use different
portfolio performance measures:
φ
Given a portfolio allocation φ, we denote by rt the return of this portfolio at time t.
• Sharpe ratio (SHR): that represents at time t the ratio of the empirical mean return
of a portfolio over its empirical standard deviation over the period [t − w, t − 1].
We denote:
φ
φ µ(rt−w,t−1 )
SHRt ≡ φ
.
σ(rt−w,t−1 )
• Sortino Price ratio (SOR): that represents at time t the ratio of the empirical mean
return of a portfolio over the empirical standard deviation of its negative returns
over the period [t − w, t − 1]:
φ
φ µ(rt−w,t−1 )
SORt ≡ φ φ
.
σ(rt−w,t−1 {rt−w,t−1 < 0})
• Gain Loss ratio (GLR): which is the ratio of total positive returns over total negative
returns:
φ
φ {rt−w,t−1 > 0}
GLRt ≡ φ .
{rt−w,t−1 < 0}
• Winner Loser ratio (WLR): similar to the Gain Loss ratio, it is the ratio of the
number of total positive returns over the number of total negative returns:
φ φ
φ rt−w,t−1 {rt−w,t−1 > 0}
WLRt ≡ φ φ
.
rt−w,t−1 {rt−w,t−1 < 0}
The following two measures are used to compare different portfolio performances.
• Certain equivalent (CER): corresponds to the equivalent risk-free return of the

portfolio return (the portfolio return adjusted for its risk aversion-adjusted standard
deviation), as used by DeMiguel et al. in their comparative study of portfolios
performance [8]:
φ φ φ
CERt ≡ µ(rt−w,t−1 ) − σ 2 (rt−w,t−1 ).
• Turnover (T/O): corresponds to the change in portfolio weights from one rebalance
period to the next. The investor aims to reduce the turnover as trading implies costs
(exchange fees, price impact, etc.):
φ

N
T/Ot ≡ |φti − φt−1
i
|.
i=0
As mentioned in Sec. 13.2.3, we consider as an estimate for π the relative performance

measure of a model within the class of models. Similarly, γ is estimated by the inverse
absolute performance measure of a model (the worse the performance, the bigger the
ambiguity aversion). Note that if the performance measure of a model is zero, then π
and γ are defaulted to zero.
13.4.3. Results
First we describe the individual performances of the eight models considered. Then, we
show how the Subjective Expected Utility portfolios of Savage (as defined in Eq. (13.2)
and where the single strategies are linearly weighted by the weighted average of their
different performance measures) outperform the individual strategies. We use the SEU
portfolios as benchmarks for our ARA methodology, as the Klibanoff et al. model is
almost impossible to compute for a large universe of assets. Finally, we display the
performances of the ambiguity robust portfolios, parametrized by the four different
performance measures considered. We conclude that the ambiguity robust portfolios
outperform by far the non-ambiguous SEU portfolios.
13.4.3.1. Performances of the different models

We display in Table 13.1 the statistics of the different strategies, computed over the
over the period January 2000 to April 2008 and annualized.
We use the four performance measures described previously to parametrize π
and γ and construct our ambiguity robust portfolios. At each date t, we compute the
Table 13.1 Strategies Performances.
UC PE CF PB
µ (%) 8.71 11.04 5.42 1.89

µ̄ (Bps) 0.43 0.54 0.26 0.09
σ (%) 3.95 4.38 5.06 4.93
max(µ) (Bps) 210.82 193.83 225.39 234.74
min(µ) (Bps) −139.12 −217.76 −205.43 −234.40
SHR 0.27 0.31 0.13 0.05
SOR 0.40 0.44 0.19 0.07
GLR (%) 104.94 105.88 102.48 100.88
WLR (%) 100.60 102.52 99.11 98.72
CER (Bps) 0.39 0.50 0.21 0.04
T/O (%) 135.01 141.51 140.83 141.59
EW MN MV CA
µ (%) 69.74 35.03 10.68 13.95

µ̄ (Bps) 3.41 1.71 0.52 0.68
σ (%) 15.26 6.77 4.75 4.71
max(µ) (Bps) 470.80 199.81 133.63 182.75
min(µ) (Bps) −540.82 −317.57 −219.94 −162.10
SHR 0.56 0.63 0.27 0.36
SOR 0.72 0.75 0.32 0.52
GLR (%) 110.48 112.05 104.98 106.77
WLR (%) 119.16 123.96 122.98 101.00
CER (Bps) 2.94 1.62 0.48 0.64
T/O (%) 2.89 21.85 28.60 135.31
performance measure of the different strategies over the historical returns between date
t − 120 and t − 1. Even though the strategies UC and CA returns underperform the EW
strategy return over the whole period considered (the equally weighted portfolio has the
biggest total return of almost 70%), there exist some periods where the reverse is true
(in 2002 for instance, the CA and UC portfolios perform better). This confirms that the
relative weight of each models should be dynamic, as proposed in our ambiguity robust
methodology. In order to have numbers of similar magnitude, we scale the inverse
Sharpe and Sortino measures by a reference ratio of three annualized: in practice, it
means that an investor considers a portfolio for which the return is three times as big
as its risk as benchmark. We have also capped the performance measures by three
to prevent a strongly performing model dominating the others. Formally, we have:
SHR = min(max(0, SHR 3
), 3) and SOR = min(max(0, SOR 3
), 3).
13.4.3.2. SEU portfolio

In Table 13.2 are displayed the performances and statistics for the SEU portfolios that
weight the different models linearly with the measure π (respectively computed with
the four different performance measures Sharpe, Sortino, Gain Loss and Win Lose
Ratios), without considering the absolute ambiguity adjustment from the function ψ.
The SEU portfolios outperform almost all the single strategy portfolios. The SEU
portfolios outperform the individual strategies, however, we improve greatly these
performances with our Ambiguity Robust approach as we show below.
13.4.3.3. Ambiguity robust portfolios

We have computed the performance of the four different Ambiguity Robust portfo-
lios (where the ambiguity parameters γ and π are estimated using the four different
Table 13.2 SEU Strategies Performances.
SHR SOR GLR WLR
Total return (%) 77.59 75.26 55.72 59.58

Mean daily return (Bps) 3.79 3.68 2.72 2.91
Volatility (%) 7.06 6.92 6.89 6.95
Max return (Bps) 326.58 322.47 310.73 321.65
Min return (Bps) −411.38 −412.40 −275.82 −270.02
SHR 1.34 1.33 0.99 1.05
SOR 1.52 1.50 1.25 1.33
GLR (%) 128.85 128.59 119.60 120.95
WLR (%) 135.45 135.09 121.06 123.23
CER (Bps) 3.69 3.58 2.63 2.81
T/O (%) 76.33 78.26 112.96 112.65
Table 13.3 Ambiguity Robust Strategies Performances.
SHR SOR GLR WLR
µ (%) 158.37 157.04 151.82 149.43

µ̄ (Bps) 7.74 7.67 7.42 7.30
σ (%) 5.22 5.27 5.70 6.11
max(µ) (Bps) 271.44 279.05 262.80 264.90
min(µ) (Bps) −206.80 −209.66 −189.94 −186.81
SHR 3.71 3.64 3.25 2.98
SOR 5.59 5.44 4.66 4.22
GLR (%) 196.40 193.90 181.26 172.80
WLR (%) 158.16 155.50 155.36 155.49
CER (Bps) 7.68 7.62 7.35 7.23
T/O (%) 137.35 138.88 136.28 134.73
RAA 0.25 0.23 0.34 0.37
AAA 0.24 0.14 0.20 0.35
performance measures: Sharpe, Sortino, Gain Loss and Win Lose ratios). In Table 13.3,
we display the statistics of the Ambiguity Robust portfolios estimated with the γ and
π measures. The RA portfolios outperformed the best CA strategy portfolio in terms
of all four different performance measures considered.
The Absolute Ambiguity Aversion (AAA) and the Relative Ambiguity Aversion
(RAA) measures allow us to quantify our ambiguity adjustment. The biggest ambiguity
adjustments are made for the less performing strategies (based on Win Lose and Gain
Loss ratios). As we can see, the Ambiguity Robust Portfolios outperform all the SEU
portfolios, meaning that the ψ adjustments enhance the performance of ambiguity
averse investors portfolios.
13.5. CONCLUSION
Our aim was to provide the reader with a simple and easy to implement methodology
for practitioners who want to allocate in a robust way their portfolio of assets when
they have several models for the asset returns distributions but they are ambiguous
about each of them (i.e., they do not fully trust them). We propose a simple, robust,
and systematic method of combining the different weights computed conditionally per
model. The concrete methodology we develop enables to account for ambiguity via
practical empirical measures, such as the performance measures of each conditional
portfolio.
Our method is very different from the approach proposed in the literature and in
particular that of Klibanoff et al. as we do not proceed to a unique complex optimization
that is extremely challenging to solve in practice. Our approach is more practical and
very industry-oriented: practitioners can easily define the optimal weights for each of
the models they consider, then they can mix those prior conditional weights, taking into
account the absolute and relative ambiguity they have against each model, as reflected
by the concavity of ψ and the weight π(Q) attributed to each model Q.
The parametrization we propose for the Absolute Ambiguity Aversion and the
Relative Ambiguity Aversion in our empirical example is by no means optimal. How-
ever, we have shown that it can greatly enhance the performance of some classical
portfolio strategies. The proposed robust ambiguity portfolio is more stable, with a
lower turnover, and less risky, with a higher certainty equivalent ratio, than unadjusted
portfolios as well as SEU portfolios. The ARA methodology smoothens and reduces
the risk of classical strategies. One of the main features of the ARA methodology is to
provide a dynamic adjustment for model uncertainty. As the parametrization depends
on the past performance of the strategy, it would be interesting to study how the ARA
model would behave in major downturns, and adapt to different market regimes.
References
[1] Markowitz, H (1952). Portfolio selection. Journal of Finance, 7, 77–91.

[2] Savage, L (1954). The Foundations of Statistics. New York: Wiley.
[3] Ellsberg, D (1961). Risk, ambiguity and the savage axiom. Quarterly Journal of Eco-
nomics, 75, 643–669.
[4] Gilboa, I and D Schmeidler (1989). Maxmin expected utility with a non-unique prior.
Journal of Mathematical Economics, 18, 141–153.
[5] Klibanoff, P, M Marinacci and S Mukerji (2005). A smooth model of decision making
under ambiguity. Econometrica, 73, 1849–1892.
[6] Barrieu, P and S Tobelem (2009). Robust asset allocation under model risk. Risk Magazine.
[7] Epstein, L and M Schneider (2007). Learning under ambiguity. Review of Economic
Studies, 74(4), 1275–1303.
[8] DeMiguel, V, L Garlappi and R Uppal (2009). Optimal versus naive diversification: How
inefficient is the 1/n portfolio strategy? Review of Financial Studies, forthcoming.
14
SEMI-STATIC HEDGING
STRATEGIES FOR EXOTIC
OPTIONS∗
HANSJÖRG ALBRECHER†,§ and PHILIPP MAYER‡,¶

†
Institute of Actuarial Science, University of Lausanne,
Quartier UNIL-Dorigny, Bâtiment Extranef,
1015 Lausanne, Switzerland
‡
Department of Mathematics, Graz University of Technology,
Steyrergasse 30, 8010 Graz, Austria
§
hansjoerg.albrecher@unil.ch
¶
mayer@finanz.math.tugraz.at
In this chapter, we give a survey of results for semi-static hedging strategies for exotic
options under different model assumptions and also in a model-independent frame-
work. Semi-static hedging strategies consist of rebalancing the underlying portfolio
only at certain pre-specified timepoints during the lifetime of the hedged derivative,
as opposed to classical dynamic hedging, where adjustments have to be made con-
tinuously in time. In many market situations (and in particular in times of limited
liquidity), this alternative approach to the hedging problem is quite useful and has
become an increasingly popular research topic over the last years. We summarize the
results on barrier options as well as strongly path-dependent options such as Asian or
∗ Supported by the Austrian Science Fund Project P18392.
345
346 Albrecher and Mayer
lookback options. Finally, it is shown how perfect semi-static hedging strategies for
discretely observed options can be developed in quite general Markov-type models.
14.1. INTRODUCTION
In the famous work [10] of 1973, it was shown how a standard European option can
be replicated by dynamically trading the underlying asset and investing in the riskless
bond. The so-called delta hedging strategy is (with some modifications) still among
the most widely used methods to manage and reduce the risk inherent in writing
an option. However, already in [60] static “hedging” methods were applied to relate
different option prices, and also the Put–Call–Parity, which at least goes back to [76],
can be interpreted as a consequence of a particular static hedging strategy. Recently,
in [39], some pitfalls of the dynamic replication strategies were outlined and it was
argued in favor of the more robust static replication methods, which in the meantime
attained quite some attention in the practical and academic literature, starting in the
mid-1990’s with [14, 37].
The semi-static hedging approach structurally differs from the dynamic counter-
part in terms of hedging instruments and trading times. While dynamic hedges base
on the assumption of being able to trade continuously in time, semi-static portfolios
do not need to be adjusted dynamically but only at pre-specified (stopping) times.
Furthermore, in contrast to classic dynamic hedging, they typically use plain vanilla
(or other liquidly traded) options as hedging instruments. Studies comparing the per-
formance of semi-static and dynamic hedging strategies (as for example undertaken
in [43, 64, 79]) indicate that the semi-static ones are in many situations more robust
and able to outperform their dynamic counterparts.
Here, we aim to give an overview of the most prominent semi-static hedging
strategies for options written on some asset (e.g., a stock or an exchange rate), for
which some standard European options are liquid. In this chapter, we focus on fully
discrete strategies, i.e., we exclude the possibility of dynamic hedging (for combined
dynamic-static hedging strategies see [52, 53]). In principle, the outlined methods
directly translate to the case where the options are written on baskets of assets, but one
has to be aware that plain vanilla options with the basket as the underlying are needed
to apply the strategies in practice.
Strategies, for which the composition of the portfolio is not changed after the
initial composition except investing gains in the riskless asset are called static, and
those with a finite number of transactions are termed semi-static (semi-static strategies
can be further subclassified as done in [55]).
We also distinguish between model-dependent and model-independent strategies.
The former depend on assumptions on the asset price process (like continuity) or need
Semi-Static Hedging Strategies for Exotic Options 347
a fully specified model, while the latter are correct in any market, which is frictionless
in the following sense:
Definition 14.1 (Frictionless market). A market is called frictionless, if
• The no-arbitrage assumption holds.
• All investors are price-takers.
• All parties have the same access to relevant information.
• There are no transaction costs, taxes, or commissions.
• All assets are perfectly divisible and can be traded at any time.
• There are no restrictions on short-selling.
• Interest rates for borrowing and lending are identical.
Throughout the text, we assume frictionless markets. Although the methods work for
time-dependent interest rates as well, we (mainly for notational convenience) further
assume that the riskless interest rate is a constant r.
Definition 14.2 (Weak and strong path-dependence). An option is said to be
weakly path-dependent if the dynamics of the option price depend only on asset price
and time, i.e., the stochastic differential equation (SDE) for the option price differs
from the SDE of a vanilla option only in the boundary conditions. Otherwise the option
is said to be strongly path-dependent.
While for weakly path-dependent options, quite general methods are available, the
theory is somewhat more involved for strongly path-dependent options. Nevertheless,
we present hedging strategies for lookback options, as well as for Asian options, and
discretely sampled options in general.
The rest of the chapter is structured as follows. Section 14.2 introduces a method
to synthesize arbitrary (sufficiently regular) payoffs that depend solely on the asset
price at some later time T . In Sec. 14.3 techniques for weakly path-dependent options
are outlined. The focus lies in particular on barrier options, which are the most liquid
and best understood exotic options of this kind. Section 14.4 deals with two examples
of strongly path-dependent options (the lookback and the Asian option) and shows
some robust hedging strategies. In Sec. 14.5, discretely sampled options, which may
be weakly path-dependent (e.g., discretely monitored barrier options) or strongly path-
dependent (e.g., Asian options) are considered. Finally, Sec. 14.6 concludes and points
out some potential future research topics.
14.2. HEDGING PATH-INDEPENDENT OPTIONS
Now consider options with a path-independent payoff. To fix ideas let us denote the
price process of some asset S up to time T by ST = {Ft }0≤t≤T and the payoff function
by p, so that p(ST ) = p(ST ). Moreover we assume that there is a riskless bond

available which pays off 1 at time T .
14.2.1. Plain Vanilla Options with Arbitrary Strikes are Liquid

First we suppose that standard European options with maturity T are liquid for all
strike levels K ≥ 0, and the payoff function p is assumed to be twice differentiable.
Then the Taylor expansion implies
S
p(S ) = p(K∗ ) + p (K∗ )(S − K∗ ) + p (x)(S − x)dx.
K∗
Since (S − x) = (S − x)+ − (x − S )+ , we can rewrite this to obtain
p(S ) = p(K ∗ ) + p (K∗ )(S − K∗ )

∞ K∗
+
+ p (x)(S − x) dx + p (x)(x − S )+ dx. (14.1)
K∗ 0
Note that (14.1) holds for any K ∗ and even extends to cases where p is not twice
differentiable (e.g., for a convex payoff function, p should then be understood as left
derivative and p as a positive measure).
For hedging purposes, we can rewrite (14.1) as
p(S ) = p(K∗ ) + p (K∗ )(F − K ∗ ) + p (K∗ )(S − F )

∞ K∗
+ p (x)(S − x)+ dx + p (x)(x − S )+ dx,
K∗ 0
where F denotes the forward price of the asset. In this way, the payoff of the contingent
claim p is decomposed into four parts, two of which are hedgeable by static positions
in the riskless bond and a forward on the asset. The other two are synthesized by
“infinitesimal” positions in standard European options. In total we get the following
static hedging strategy (cf. [22]):
Payoff Hedged by positions in
p(K ∗ ) + p (K∗ )(F − K ∗ ) (p(K ∗ ) + (F − K ∗ )p (K ∗ )) bonds

p (K∗ )(ST − F ) p (K∗ ) forwards
∞ +
K ∗ p (x)(ST − x) dx p (x)dx calls struck at x (∀x ∈ [K∗ , ∞))
K∗ +
0 p (x)(x − ST ) dx p (x)dx puts struck at x (∀x ∈ [0, K∗ ))
This means that if European calls and puts with maturity T are liquid for all strikes,
any (sufficiently regular) contingent claim on the time-T -price of S can be replicated
perfectly — regardless of the model assumptions and in particular also in incomplete

market models (this fact was already noticed e.g., by [11, 47, 62, 71]).
A nice application of Formula (14.1) was given in [22], where it was shown that
a variance swap written on some forward F can be replicated by a contingent claim
with payoff ln(FT ) and a dynamic trading strategy involving the forward (see also
e.g., [18, 19, 38, 42] for further details).
It is worth noting that (14.1) also yields a pricing formula for the contingent claim.
Denote by C(Ft , t; K, T ) and P(Ft , t; K, T ) the call and put price at current time t,
respectively. Since due to the first fundamental theorem of asset pricing (see [35]) the
price of the claim in an arbitrage-free setup is given as the risk-neutral expectation
(conditioned on Ft ) of the discounted payoff, we have (the forward contract has value
0 by definition)
EQ [e−r(T −t) p(ST )|Ft ] = e−r(T −t) p(K∗ ) + e−r(T −t) (Ft − K∗ )p (K∗ )
∞ K∗
+ p (x)C(Ft , t; x, T )dx + p (x)P(Ft , t; x, T )dx, (14.2)
K∗ 0
where interchanging the order of integration is justified whenever the integrands in

this last formula are absolutely integrable.
A straightforward corollary to the above formula is the familiar Put-Call-Parity
C(Ft , t; K, T ) = e−r(T −t) (Ft − K) + P(Ft , t; K, T ), (14.3)
which is obtained by setting p(S ) = (S − K)+ and choosing K∗ > K (Ft denotes the
time t-forward price of the asset). Note that (14.1) furthermore implies the following
static hedging portfolio for the call payoff:
• A long position in a put with the same strike K and maturity T as the call
• A long position in a forward contract
• Investing exp(−rT )(Ft − K) in the bond
It is easy to see that the payoff of this portfolio at time T is the same as provided by
the vanilla put, and the hedging strategy is therefore correct.
14.2.2. Finitely Many Liquid Strikes

The derivation of the perfect hedging strategies in the last section relied on the assump-
tion that standard European options are liquid for arbitrary strikes. In reality, of course,
there are only a finite number of maturity/strike combinations available on the market.
The first question in this more realistic context is whether the option prices them-
selves are consistent with the no-arbitrage assumption. This question is, for instance.
addressed in [21] and in a general setting in [32] (see also [28]).
Now, given a set of traded option prices, one can derive no-arbitrage bounds
for the price of contingent claims by solving a semi-definite optimization problem
(see [9,51], where also more general options are considered). The dual of this problem
is then to find the most expensive sub- and the cheapest super-replicating strategy using
static positions in liquid options. The latter question is obviously highly relevant in
practical applications, as it shows an (in some sense) optimal way to cover the payoff in
any case.
Alternatively the right hand side of (14.1) may be approximated by a sum, where
the sampling points correspond to the liquid strikes. However, then one cannot ensure
that the payoff of the hedging portfolio is sufficient to cover the payoff of the contingent
claim, unless the weights of the liquid options are chosen with great care.
14.3. HEDGING BARRIER AND OTHER WEAKLY PATH

DEPENDENT OPTIONS
The prototype of a weakly path-dependent option is the barrier option, which, starting
from [14], has attracted by far the most attention in the literature of semi-static hedging.
The payoff of a barrier option generally depends on whether the asset price has reached
some pre-specified region up to maturity or not.
For example, the Down-and-Out call (DOC) with parameters strike K, barrier
B < S0 , and maturity T has the payoff
p(ST ) = (ST − K)+ 11{inf 0≤t≤T Ft >B} , (14.4)
where 11A denotes the indicator function of the set A.

Analogously the payoff of a Down-and-In call (DIC) is defined by
p(ST ) = (ST − K)+ 11{inf 0≤t≤T Ft ≤B} .
In a similar manner the payoff of Up-and-Out and Up-and-In calls (UOC and UIC)
are defined by
p(ST ) = (ST − K)+ 11{sup0≤t≤T Ft <B}
and
p(ST ) = (ST − K)+ 11{sup0≤t≤T Ft ≥B} ,
respectively, and the put counterparts are defined analogously.

Variants of the standard barrier options include double barrier options (where the
barrier region is two-sided) or barrier options with rebates. Here, we mainly focus on
the standard ones (note that in [72] it is shown in the Black-Scholes model how double
barrier options can be replicated by single barrier options).
Since the plain vanilla option payoff obviously dominates the barrier option payoff,
a first simple super-replicating portfolio for the considered barrier option is a long
position in a standard European option with the same strike and the same maturity.
Let us denote the time-t-price of a Down-and-Out and a Down-and-In call with
strike K, barrier B, and maturity T by DOC(Ft , t; K, T, B) and DIC(Ft , t; K, T, B),
respectively. Since the sum of the payoff of a DOC and a DIC with the same parameters
equals the payoff of a plain vanilla call, we have by the law of one price
C(Ft , t; K, T ) = DOC(Ft , t; K, T, B) + DIC(Ft , t; K, T, B). (14.5)
Analogous equations hold for UOC and UIC prices and naturally for the corresponding
put options as well.
In the remainder of this section, the DOC serves as the illustrating example.
Extensions to other option types are often analogous.
In practice, early-exercise or cancellation features additionally play a role. The
interested reader is referred to [65] for an optimization based treatment of super-
and sub-replicating strategies for American options and to [33, 34] or [8] for hedging
strategies of installment options.
Let us assume that the barrier option with maturity T is written on the time T
forward price FT of an asset and let us use the forward price as the underlying. For
convenience, the prices of all options are w.l.o.g. expressed with respect to this forward
price in the rest of the section.
Any barrier option can be adapted to this notation, simply by replacing the original
constant barrier by a time-dependent one. The first hitting time τ is defined as the first
time for which the forward asset price process is at or below the (now possibly time-
dependent) barrier B(t),
τ = inf{t ≤ T : Ft ≤ B(t)},
with the convention inf ∅ = ∞.
14.3.1. Model-Dependent Strategies: Perfect Replication

First we assume that the barrier B(t) ≡ B for the forward is constant and we suppose the
forward price process Ft to be continuous. The following is a nice and conceptionally
simple semi-static hedging strategy for a DOC written on the forward price of an asset
(with strike K, maturity T , and barrier B = K at the strike):
• Buy a standard European call struck at K and maturing at T and sell a European put
with the same parameters.
• The first time the forward price touches the barrier close the positions.
• If the barrier is never hit, hold the portfolio until expiry.
This perfectly replicates the payoff of the DOC, as follows by considering the two
different sacenarios:
• The barrier is not reached until maturity: then the payoff of the portfolio is the same
as the one of the DOC, i.e., (ST − K), as necessarily ST = FT ≥ B = K;
• The barrier is hit at τ < T : then
C(Fτ , τ; K, T ) = P(Fτ , τ; K, T ),
because of the Put–Call–Parity (14.3) (recall that Fτ = K). Thus the cost of closing
the positions is 0 and the payoff of the DOC is replicated also in this case.
The price of the DOC is hence given by
DOC(F0 , 0; K, T, K) = C(F0 , 0; K, T ) − P(F0 , 0; K, T ). (14.6)
This hedging strategy is rather simple (and — due to the involved continuity assump-
tion — model-dependent). But it is not straight-forward to extend this kind of strategy
to other types of barrier options (an exception is the barrier exchange option, see [57]).
Thus there is the need for a more general approach.
One of the most famous semi-static hedging strategies for barrier options was
originally developed by Carr and Bowie [14] (see also [15–17]) and is based on a
relation between standard European calls and puts with different strikes:
Assumption 1. Denote the current time by t. For any T ≥ t the implied volatility
smile (for maturity T ), plotted as a function of the log-moneyness, is symmetric. More
precisely: let K and H√ be such that the geometric mean of K and H is the current
forward price Ft , i.e., KH = Ft , then
σimp (K) = σimp (H ).
Theorem 14.1 (Put-Call-Symmetry, [17]). Given √a frictionless market, under

Assumption 1 the following holds for all K, H with KH = Ft :

K
C(Ft , t; K, T ) = · P(Ft , t; H, T ), ∀T ≥ t.
H
We shortly sketch the proof of the above theorem: recall that the price of a call in the
Black-Scholes model (with volatility σ) is given by

C(Ft , t; K, T ) = e−r(T −t) Ft (d+ (Ft /K)) − K(d− (Ft /K)) ,
where Ft is the forward price of the asset,
log(x) ± 12 σ 2 (T − t)
d± (x) = √ ,
σ T −t
and
√ (x) is the cumulative distribution function of the normal distribution. Due to
KH = Ft , the above is easily seen to be equivalent to

K −r(T −t)
C(Ft , t; K, T ) = e H(−d− (Ft /H )) − Ft (−d+ (Ft /H ))
H

K
= P(Ft , t; H, T ).
H
Thus as long as the implied volatility for vanilla options with strike K and H is identical
(which is Assumption 1), the theorem remains valid.
Necessary and sufficient conditions on an asset price model to fulfill Assumption 1
are given in [20]. A first example is of course the Black-Scholes model. Another is the
following local volatility model for the forward price:
dFs = Fs σ(Fs , s)dWsQ , s > t,
where Ws is a standard Brownian motion and
σ(Fs , s) = σ(Ft2 /Fs , s). (14.7)
Condition (14.7) implies that the local volatility at a fixed time s plotted as a function
of the log-returns is symmetric around 0, which explains also the symmetry of the
implied volatility surface.
Starting from Theorem 14.1, in [14] it is investigated how the Put–Call–Symmetry
can be used to hedge barrier options (a similar relation between different call and put
prices, termed Put–Call–Reversal, was used in [6] to hedge long-term call options).
Consider a DOC with strike K, maturity T , and barrier B < K. By definition, the
payoff of this option is (ST − K)+ , if the barrier was never hit and 0 otherwise. In order
to hedge the final payoff, a vanilla call with the same strike and maturity as the DOC
should be bought. Clearly this is a super-hedge and another vanilla option can be sold
such that one obtains a portfolio with value 0 at the barrier. Assuming the conditions
for the Put–Call–Symmetry at the first hitting time τ, we know that a put with the
same maturity and strike B2 /K fulfills the geometric mean condition of the theorem.
Therefore
K
C(B, τ; K, T ) = P(B, τ; B2 /K, T ).
B
Hence a portfolio consisting of a long position in the corresponding vanilla call and a
short position in K/B puts with strike B2 /K has value 0, if the forward price is exactly
at the barrier. Consequently, a replicating portfolio for a DOC is to take a long position
in a standard European call with strike K and maturity T and a short position in K/B
puts with strike B2 /K and the same maturity. The corresponding trading strategy is to
hold the portfolio until expiry, if the barrier is never hit, or to close the positions (at 0
cost) at τ ≤ T . Note that for the correctness of the replication strategy it is necessary
that the forward price is exactly B at the first hitting time (which explains the continuity
assumption).
Summing up, under the no-arbitrage principle this leads to the equation:
K
DOC(F0 , 0; K, T, B) = C(F0 , 0; K, T ) − P(F, 0; B2 /K, T ). (14.8)
B
This hedging procedure can be extended to other types of barrier options but then
typically becomes more complicated. For example, for an UOC one would also need
to take a position in a binary call (i.e., an option, which pays 1 if the asset price at
maturity exceeds the strike, and 0 otherwise) and the latter one can be hedged by the
strategies outlined in the previous section. If the assumption of a constant barrier on
the forward price is relaxed, super- and sub-replication strategies can be derived. For
the details we refer to [17] (see also the nice summary [69]). In [56], the case when
only a finite number of options with prespecified strikes are available is considered and
conditions under which a strategy based on the Put–Call–Symmetry is a semi-static
superhedge are identified.
Another hedging strategy for barrier options has its roots in papers of Derman
et al. [36,37]. In order to point out the main idea of the Derman–Ergener–Kani (D–E–K)
algorithm, a binomial model is considered first, i.e., the asset price process is assumed
to follow a binomial tree. In this setting the D–E–K-algorithm for a DOC with maturity
T , strike K, and barrier B is as follows:
• Identify the boundary nodes, i.e., the maturity and the barrier nodes and denote the
resulting time grid by t1 < · · · < tn ;
• Buy a standard European option replicating the payoff of the barrier option if the
barrier boundary is not hit during the lifetime of the barrier option. In the case of a
DOC with B < K this would be a standard European call with the same strike and
maturity as the barrier option;
• Choose n options with different maturities Ti and strikes Ki having payoff 0 if the
barrier was not hit. In the example of a DOC, one could for instance choose puts
with strikes Ki ≤ B and maturities Ti ≤ T . Then solve the linear equation system
Vi · w + C(B, ti ; K, T ) = 0, i = 1, . . . , n (14.9)
for w, where
Vi := (P(B, ti ; K1 , T1 ), P(B, ti ; K2 , T2 ), . . . , P(B, ti ; Kn , Tn ))
denotes the vector of the time-ti -prices of the n additional options and · is the scalar
product.
Note that due to (14.9) the portfolio consisting of the option replicating the final payoff
and wi options with strike Ki and maturity Ti can be sold at zero cost at every barrier
node and thus the semi-static trading strategy of holding the portfolio until expiry in
case the barrier has not been hit, or to close the positions at the first hitting time, is a
perfect replication of the barrier option.
In the binomial framework the D–E–K-algorithm thus gives a perfect hedge for
all kinds of barrier options — in particular also for double-barrier options and options
with a time-dependent barrier — as long as enough different standard European options
are liquid (i.e., at least as many as there are barrier nodes). However, since the prices
in (14.9) are model-dependent (as they have to be calculated using a model — in the
above case the binomial model), the entire portfolio is model-dependent.
For continuous-time models, the approach outlined in [37] is to discretize (in time)
the asset price process and hedge the values at the discrete monitoring times. In [78],
the effectiveness of such a discretization for stochastic volatility is examined and it is
found that it works well for a small volatility of volatility, but not satisfactory in the
opposite case combined with discontinuous final payoff of the barrier option (as for
an UOC). We come back to better alternatives in the next section.
A possible limit strategy for continuous-time price models can be achieved by
assuming standard options with all strikes and maturities to be liquid. This strategy was
developed by Andersen et al. [5] (see also [61]), who observed that the key assumption
on the price model is that the price of European options, besides their parameters, only
depends on the current time t and asset price Ft (this assumption for instance rules out
stochastic volatility models). The approach is, as the D–E–K-algorithm, very powerful
in terms of the barrier structure and allows for arbitrary (sufficiently regular) functions
of time.
For the ease of exposition we assume that the forward price again follows a local
volatility model in the risk-neutral world (the method can be extended to more general
Markov-type models), i.e.,
dFt
= σ(Ft , t)dWt , (14.10)
Ft
where σ is now just assumed to be positive and sufficiently regular to admit a unique
solution of Eq. (14.10).
Consider again the standard example of a DOC on the forward price of an asset
with dynamics as specified in (14.10). Then the following PDE specifies the price
function G(Ft , t) of a DOC with strike K, barrier B, and maturity T started at time t
(and has in particular not reached the barrier up to the time t):
1
Gt (F, t) + σ 2 (F, t)F 2 GFF (F, t) = 0, t < T, F > B
2
G(F, t) = 0, t < T, F ≤ B (14.11)
+
G(F, T ) = (F − K) ∀F,
where we assumed again for simplicity, that B < K.

Then
G(F, t) = DOC(F, t; K, T, B),
in case the asset price has not crossed the barrier before t. If the function σ in (14.11) is
sufficiently regular, G(F, t) is twice differentiable with respect to F , except at F = B,
where the (formal) second derivative is given by δ(F − B)G+ F (B, t) (δ denoting the
+
Dirac Delta measure and GF the right derivative). Using (14.11) and a generalized
Meyer–Itô-formula (see [68]), one finds:
T
(FT − K)+ = G(F0 , 0) + 11{Ft >B} GF (Ft , t)Ft σ(Ft , t)dWt
0
T
1
+ G+ B
F (B, t)dLt ,
2 0
where LBt is the local time of F at B and hence fulfills

T
1
LBt = lim 11{B≤Fs ≤B+} σ 2 (Fs , s)Fs2 ds a.s. (14.12)
→0 0
Rearranging the terms gives:

T
+ 1 T +
G(F0 , 0) + 11{Ft >B} GF (Ft , t)dFt = (FT − K) − G (B, t)dLBt . (14.13)
0 2 0 F
Using (14.12) and (14.13), one might deduce the following semi-static hedge for
the DOC: take a long position in a call with strike K and maturity T and short
positions in G+ F (B(t), t)dt options with maturity t (∀ 0 ≤ t ≤ T ) and payoff
11{B≤Ft ≤B+} σ 2 (Ft , t)Ft2 / ( very small). Note that the latter payoff can, for any > 0,
be approximated arbitrarily closely by standard options (we assumed options for all
maturities and strikes to be liquid). The corresponding trading strategy is to hold the
portfolio until expiry, if the barrier is not reached and to sell the portfolio at the first
hitting time τ. This is in fact a nearly perfect replication strategy, which can be seen by
considering the limiting case for → 0: if the barrier is not reached, then the payoff
of the replicating portfolio equals the payoff of the call option and thus the payoff of
the DOC. On the other hand, with (14.13) we have
T

E G(F0 , 0) + 11{Ft >B(t)} GF (Ft , t)dFt Fτ
0

+
T
1 + B

= E[(FT − K) |Fτ ] − E G (B, t)dLt Fτ ,
0 2 F
which can be reformulated as

τ
1 τ +
G(F0 , 0) + 11{Ft >B(t)} GF (Ft , t)dFt + G (B, t)dLBt
0 2 0 F
T
1 + B

= C(B(τ), τ; K, T ) − E GF (B, t)dLt Fτ ,
2 τ
where the right-hand-side is exactly the time-τ-price of the portfolio. Note that at this
point it is crucial that the prices of European options only depend on the asset price at
time τ in order to interpret the expectations as prices. Since
τ
1 τ +
G(F0 , 0) + 11{Ft >B(t)} GF (Ft , t)dFt + G (B, t)dLBt = G(B(τ), τ)
0 2 0 F
and G(B(τ), τ) = 0 by definition, the value of the portfolio at time τ is 0. Thus we can
close the positions at zero cost and replicate the payoff of the DOC.
This replication strategy can be generalized to all kinds of terminal payoffs, barrier
regions, rebates, and also to jump-diffusion processes. We refer to [5] for details.
An interesting difference to hedging strategies using the Put–Call–Symmetry is
that here not only the correctness, but also the strategy itself depends on the model.
More precisely: the number G+ F (B(t), t) has to be calculated using a model, while the
strategy outlined before is independent of the exact specification of the local volatility,
as long as Assumption 1 is fulfilled.
14.3.2. Model-Dependent Strategies: Approximations

The hedging strategies in the previous sections were perfect if the model was correct,
i.e., the risk of the option could be completely eliminated. In particular, this gave further
insight into the underlying models and into relations between barrier options and
standard European options. However, the perfect replication could only be achieved at
the cost of more or less severe assumptions like liquidity of arbitrary standard European
options or restrictions on the model. In this section a different and in some sense more
pragmatic approach to semi-static hedging is discussed.
In the previous section we discussed an algorithm for a binomial model (although
already Derman et al. generalized the approach to continuous time models). A key
point of this generalized D–E–K algorithm is that the barrier is hit exactly and that the
prices of the European options only depend on the asset price. This assumption is too
restrictive, as for example stochastic volatility or price jumps cannot be accommodated
in this framework. Therefore, a lot of research in recent years has been devoted to
generalize the assumptions, but keeping the main idea of matching the barrier option
value at the first hitting time. Examples of such studies are [4,44,46,58,59,63,64,75].
To outline the basic ideas of these generalizations, we focus again on a DOC. As

in the D–E–K algorithm, we take a long position in a call with the same maturity and
strike as the DOC to cover the payoff at maturity in the case the barrier was not hit.
Thus the aim is to take positions in other options, such that the value of the portfolio
is 0 if the barrier is hit. Furthermore the additional options should not have any payoff
if the asset price stays above the barrier during the lifetime of the barrier option. In a
binomial world this could be done by solving equation system (14.9). For general asset
price dynamics, this equation system has to be replaced by something more general
and the method of choice of the above cited studies is to consider different scenarios
for the portfolio value at the hitting time.
To fix ideas, let denote the set of possible scenarios for the evolution of the
barrier option. Then an element θ ∈ consists of
• The time when the barrier is hit (the hitting time)
• The undershoot of the asset price under the barrier
• The form of the implied volatility surface at the hitting time (i.e., The prices of the
used European options at the hitting time)
Thus we have to solve
Vθ · w + Cθ (Fτθ , τθ ; K, T ) = 0, θ ∈ , (14.14)
where Vθ is the price vector of the options and Cθ (Fτθ , τθ ; K, T ) is the price of the call
option at the hitting time τθ under scenario θ. Note that the asset price Fτθ ≤ B(τθ ) is
allowed to undershoot the barrier.
As is an infinite set in general, (14.14) consists of a continuum of linear equa-
tions, which is obviously not feasible.
Hence the set has to be discretized to make (14.14) a finite-dimensional equation
system. This can be done by assuming a model and using Monte-Carlo simulation (see
e.g., [46, 63, 64, 75]) or by an a-priori choice of “reasonable” scenarios [4, 59]. The
implied volatility surface at the hitting time, i.e., Vθ and Cθ , can be calculated using
a pre-specified model, or can be allowed to vary in some reasonable manner (e.g., by
allowing the parameters of the model to take a set of values [59]) in order to make the
hedge robust with respect to model risk.
After a discretization of (14.14), the number of equations, albeit finite, may be
huge, if a large number of different scenarios is considered. However, since the number
of scenarios is directly linked to the error due to discretization, it should in fact be
chosen large in order to obtain robust results. As in general only a limited number of
different options is liquid, we cannot hope to be able to solve even a discretized version
(14.14) exactly. To overcome this problem, several approaches are feasible. [75] (see
also [63, 64]) proposes to minimize a risk measure of the hedging error under the
budget condition that the price of the hedging portfolio is smaller or equal to the one
of the barrier option. Alternatively, in [46,58,59] it is suggested to modify the equation
to an inequality, such that the trading strategy becomes a super-replication and then
minimize the cost of this hedge.
14.3.3. Model-Independent Strategies: Robust Strategies

In the preceding section the problem of making the hedging strategies robust with
respect to model risk was already mentioned. Now let us sharpen the question: what
can be deduced on the price of the barrier option if the market is solely assumed to
be frictionless? In particular, robust super- and sub-replicating strategies for barrier
options are considered. Those strategies are called robust because they over- (respec-
tively under-) hedge the barrier option in any frictionless (and in particular arbitrage-
free) market model. For barrier options, these were first developed by Brown et al. [12]
(for some recent extensions see [29, 30]).
In order to outline the approach, assume again a forward market model and a
constant barrier on the forward price (the ideas can be extended to time-dependent
barriers, but the price intervals implied by the hedges might increase). Consider again
the DOC with strike K, maturity T , and barrier B.
If K ≥ B, then for any γ̃ > K a sub-replicating portfolio for the DOC is
given by:
• A long position in a call with strike K and maturity T
• A short position in (γ̃ − K)/(γ̃ − B) puts with strike B and maturity T
• A short position in (K − B)/(γ̃ − B) calls with strike γ̃ ∨ K
The corresponding trading strategy is to hold the portfolio until expiry if the barrier is
not reached and otherwise to unwind the positions at the first hitting time.
To show the sub-replication property of this semi-static strategy, let us again
distinguish the two cases:
• If the barrier is not hit, the payoff of the strategy is
K−B
(ST − K)+ − (ST − γ̃)+ ≤ (ST − K)+ ,
γ̃ − B
where the right-hand side corresponds to the payoff of the DOC;
• If the barrier is hit at time τ, then Ft = B − x, where x ≥ 0 denotes the (possible)
undershoot. Hence for the value Vτ of the portfolio we find
γ̃ − K K−B
Vτ = C(B − x, 0; K, T ) − P(B − x, 0; B, T ) − C(B − x, 0; γ̃, T )
γ̃ − B γ̃ − B
γ̃ − K K−B
≤ C(B − x, 0; K, T ) − C(B − x, 0; B, T ) − C(B − x, 0; γ̃, T )
γ̃ − B γ̃ − B
≤ 0,
where the first inequality follows from the Put–Call–Parity (14.3) and the second
one from the convexity (in K) of the call price (or alternatively by a direct look at
the final payoff of the last portfolio).
The portfolio is thus a subreplicating one for any γ̃ and hence γ̃ can be chosen such
that the initial value V of the portfolio is maximized. Since
γ̃ − K K−B
V = C(F0 , 0; K, T ) − P(F0 , 0; B, T ) − C(F0 , 0; γ̃, T )
γ̃ − B γ̃ − B
K−B
= C(F0 , 0; K, T ) − P(F0 , 0; B, T ) + (P(F0 , 0; K, T ) − C(F0 , 0; γ̃, T )),
γ̃ − B
the optimal γ̃ is given by
P(F0 , 0; B, T ) − C(F0 , 0; β, T )
γ̃ = argmaxβ>K .
β−B
If K < B, then a sub-replicating portfolio for the DOC is given by:
• A long position in a forward contract (with forward price F0 )

• A long position in F0 − K bonds
• A short position in (B − K)/(γ − B) puts with maturity T and strike γ > B
The trading strategy is the same as before and the subreplication property is again
shown by distinguishing two cases:
• If the barrier is not hit, we have for the payoff of the strategy
B−K
(ST − F0 ) + (F0 − K) − (γ − ST )+ ≤ (ST − K),
γ −B
where the right-hand side corresponds to the payoff of the DOC, since B > K;
• If the barrier is hit at time τ, then Ft = B − x. Thus the time-τ-value of the long
position in the forward is exp(−r(T − τ)) (B − x − F0 ) and hence for Vτ we find
Vτ = e−r(T −τ) (B − x − F0 ) + e−r(T −τ) (F0 − K)
B−K
− P(B − x, τ; γ, T )
γ −B
B−K
≤ e−r(T −τ) (B − K) − P(B, τ; γ, T )
γ −B
B − K −r(T −τ)
≤ e−r(T −τ) (B − K) − e (γ − B) = 0,
γ −B
where the first inequality follows from the monotonicity of the put price and the
second one from the Put–Call–Parity (14.3).
Similarly as in the case K > B it can be shown, that the optimal choice for γ, i.e., the
one maximizing the initial value of the portfolio, is given by
P(F0 , β, 0, T )
γ = argminβ>B .
β−B
Super-replicating portfolios are in both cases found by omitting the barrier feature in
the final payoff, i.e., they are given as the trivial super-hedges consisting of
• A long position in a call with maturity T and strike K, if K ≥ B
• A long position in a call with maturity T and strike B and in B − K binary calls (a
path-independent option with payoff 11{ST ≥B} ) with strike B, if K < B
Of course the sub- and super-hedging strategies also imply price bounds on the DOC:
If K ≥ B we have
γ̃ − K K−B
C(F0 , 0; K, T ) − P(F0 , 0; B, T ) − C(F0 , 0; γ̃, T )
γ̃ − B γ̃ − B
≤ DOC(F0 , 0; K, T, B) ≤ C(F0 , 0; K, T ),
while in the case K < B we have
B−K
e−rT (F0 − K) − P(F0 , 0; γ, T ) ≤ DOC(F0 , 0; K, T, B)
γ −B
≤ C(F0 , 0; B, T ) + (B − K)BC(F0 , 0; B, T ),
where BC(Ft , t; B, T ) denotes the time-t-price of a binary call with strike B, and γ̃, γ
are as before.
The particular role of these sub- and super-replication strategies is identified in
the following result:
Theorem 14.3.1 ( [12]). Assume that European options for all strikes with maturity
T are liquid and that there are no options available with maturity less than T. Then the
bounds on the price of the DOC are sharp. This means that there are forward price
processes that are martingales and consistent with the prices of the European options
for which the price of the DOC is given by the lower (resp. upper) bound. In those
market models, the hedging strategies are perfect.
The proof of this theorem is closely related to the Skorokhod problem (see also [67]).
14.4. HEDGING STRONGLY PATH-DEPENDENT OPTIONS
In this section we consider strongly path-dependent options. In particular we focus on

lookback and Asian options. For lookback options we show how barrier options (and
the corresponding hedging strategies) can be used to hedge them. For Asian options
robust hedging strategies are shown, which are related to hedging strategies for basket
options. A perfect (model-dependent) strategy for discretely sampled options (DSO),
which include Asian or cliquet options, is outlined in Sec. 14.5.
14.4.1. Lookback Options

Let us consider a floating strike lookback option (LO) with terminal payoff
p(ST ) = ST − mT ,
where mT = inf 0≤s≤T Ss .
This kind of lookback option can be hedged robustly in terms of barrier options,
as was first observed by Carr et al. [17] (see also [26, 27] for static hedging strategies
of similar insurance products). The hedging strategies are not exact but rather sub-
and super-replications and hence impose bounds on the price of the lookback option.
Along the way to obtain the hedging strategies for the lookback option, we also deal
with some other exotic options with gradually increasing complexity.
A roll-down call (RDC) with maturity T and strike K0 has two barriers H1 > H2 .
In contrast to a double-barrier option, these two barriers are both below the initial asset
price and the strike. The payoff of the RDC is specified as follows: if neither of the
two barriers is hit, then the payoff is (ST − K0 )+ . If the nearer barrier (H1 ) is hit, the
strike of the option is rolled down to this barrier and the second barrier becomes an
out-barrier. So hitting H1 the RDC becomes a DOC with strike H1 and out-barrier H2 .
For some more details concerning roll-down-calls and also roll-up-puts, see [45].
For the purpose of hedging the lookback option, the definition should be extended
as follows. Let H1 > H2 > · · · > Hn be a decreasing sequence of barriers all below
the current spot price and below the initial strike K0 . If no barrier is hit, then the
payoff is again (ST − K0 )+ . If the first barrier is hit, the strike rolls down to some level
K1 ∈ [H1 , K0 ]. If the second barrier is hit, the strike rolls down to a certain strike
K2 ∈ [H2 , K1 ]. This rolling down process is repeated until the asset price reaches (or
undershoots) Hn — the out-barrier. Thus hitting Hn knocks out the option.
The option defined above is called extended roll-down call (ERDC) and admits
the following decomposition in terms of DOC’s:
ERDC(F0 , 0; K0 , T, {Ki }1≤i≤n−1 , {Hi }1≤i≤n ) = DOC(F0 , 0; K0 , T, H1 )

n−1

+ DOC(F0 , 0; Ki , T, Hi+1 ) − DOC(F0 , 0; Ki , T, Hi ) . (14.15)
i=1
This portfolio indeed matches the payoff of the ERDC exactly, since if Hi+1 < mt ≤ Hi
(recall mt = inf 0≤s≤t Ss ), the sum in (14.15) starts with i + 1 and the leading term
DOC(F0 , 0; K0 , T, H1 ) is replaced by DOC(Ft , t; Ki , T, Hi+1 ). Thus the ERDC can

be perfectly replicated by a finite number of barrier options.
Note that the representation above is model-independent and the semi-static hedge
is perfect in all frictionless models.
Therefore, to build a semi-static hedging strategy for ERDC’s using European
options, the corresponding hedging strategies for DOC’s can be used.
The next option we want to consider is the ratchet call. The ratchet call (RC) is an
ERDC with initial strike K0 and the strikes Ki equal the barrier levels Hi for 1 ≤ i ≤ n.
Furthermore it cannot be knocked out. Thus the RC can be written as follows:
RC(F0 , 0; K0 , T, {Ki }1≤i≤n ) = DIC(F0 , 0; Kn , T, Kn )
+ ERDC(F0 , 0; K0 , T, {Ki }1≤i≤n−1 , {Ki }1≤i≤n ),
where DIC stands for a down-and-in call.

Using the model-independent representation (14.15) of the ERDC, we find:
RC(F0 , K0 , 0, T, {Ki }1≤i≤n ) = DOC(F0 , 0; K0 , T, K1 ) + DIC(F0 , 0; Kn , T, Kn )

n−1

+ DOC(F0 , 0; Ki , T, Ki+1 ) − DOC(F0 , 0; Ki , T, Ki ) . (14.16)
i=1
Consider now the floating strike lookback call, defined at the beginning of the section.
Recall that the payoff at maturity T is given by ST −mT , where mT is the minimum price
of the asset up to T . This type of lookback calls can be seen as RC with a continuum
of roll-down barriers and strikes. Due to this continuum of roll-down barriers we are
not able to find an exact hedge, but we give super- and sub-hedges for lookback calls.
It is clear that an RC with K0 = F0 and Kn = 0 undervalues the LO, because the
strike of the lookback option at time t can only be below or equal the strike of the RC.
Therefore a model-independent sub-hedge for a LO is given by:
LO(F0 , 0; T ) ≥ RC(F0 , 0; F0 , T, {Ki }1≤i≤n )
= DOC(F0 , 0; F0 , T, K1 ) + DIC(F0 , 0; Kn , T, Kn )

n−1

+ DOC(F0 , 0; Ki , T, Ki+1 ) − DOC(F0 , 0; Ki , T, Ki ) .
i=1
(14.17)
Again the barrier options might be hedged using the strategies of Sec. 14.3. Adding
more roll-down barriers obviously increases the quality of the sub-hedge, i.e., a tighter
bound is obtained.
In order to find a super-hedge for the LO, an ERDC with Ki = Hi+1 for 1 ≤ i ≤ n
and Hn+1 = 0 can be used. Such an ERDC is a super-hedge, because its strike is below
or equal to the strike of the LO throughout the lifetime of the option. Hence we have
LO(F0 , 0; T ) ≤ ERDC(F0 , 0; H1 , T, {Hi+1 }1≤i≤n , {Hi }1≤i≤n+1 )
= DOC(F0 , 0; H1 , T, H1 )

n+1

+ DOC(F0 , 0; Hi , T, Hi ) − DOC(F0 , 0; Hi , T, Hi−1 ) . (14.18)
i=2
Another portfolio having the same payoff as the one stated above is given by:
LO(F0 , 0; T ) ≤ C(F0 , 0; H1 , T ) − P(F0 , 0; H1 , T )

n−1

+ (Hi − Hi+1 ) DIB(F0 , 0; Hi , T )
i=1
+ Hn DIB(F0 , 0; Hn , T ), (14.19)
where DIB is a down-and-in digital option that pays 1 at expiry if the barrier was
hit before maturity. As for the sub-hedge, the bounds become tighter the more Hi are
added.
Note that (14.17) as well as (14.18) and (14.19) are model-independent super-
and sub-hedging portfolios, respectively.
For fixed-strike lookback options one can use similar arguments and digital options
to replicate the payoff (see [13]). Then again, the hedging strategies for weakly path-
dependent options can be used.
It is worth noting that in [48] the best model-independent bounds for lookback
options is calculated. However, the ideas are similar to the ones used for the derivation
of the robust strategies for hedging barrier options and we omit the details here.
14.4.2. Asian Options

Let K be the strike, {ti }1≤n the monitoring times, and T the maturity of an Asian call
(AC). Then the payoff p of the AC at T is given by

+
n +
1 1
n
p(ST ) = St − K = St − nK . (14.20)
n i=1 i n i=1 i
Taking the operator (·)+ inside the sum in (14.20) clearly gives an upper bound and
hence a static super-replication strategy for the AC in terms of European calls, i.e.,

+

n
+
n
Sti − nK = (St1 − K1 ) + · · · + (Stn − Kn ) ≤ (Sti − Ki )+ , (14.21)
i=1 i=1
n
whenever i=1 Ki = nK.
A simple first choice for the strikes of the calls is Ki = K ∀ 1 ≤ i ≤ n, which
is, however, not optimal. The cheapest (an hence best) choice was originally found
in [74] for complete markets and later generalized in [1, 3] (see also [25, 80]) and it
turns out that the concept of comonotonicity is a helpful tool to this end:
Definition 14.3 (Stop-loss transform). Let FX (x) be the distribution function of a

non-negative random variable X. Then the stop-loss transform FX (m) is defined by
∞
FX (m) = (x − m)dFX (x) = E[(X − m)+ ], m > 0.
m
Definition 14.4 (Comonotone random vector). Let (X1 , X2 , . . . , Xn ) be a non-

negative random vector with marginal distribution functions FX1 , FX2 , . . . , FXn . The
vector is called comonotone, if the joint distribution function FX1 ,X2 ,...,Xn is given by
FX1 ,X2 ,...,Xn (x1 , x2 , . . . , xn ) = min{FX1 (x1 ), FX2 (x2 ), . . . , FXn (xn )}.
Note that the right-hand side of the above equation is a copula (often called lower
Frechet-copula). For a general introduction to this field and proofs of the properties
used below, see [40, 41].
To simplify notation, let us assume that the marginal distribution functions are
strictly increasing. Let (X1 , . . . , Xn ) be a non-negative random vector with marginal
distribution functions FXi and suppose (Y1 , . . . , Yn ) to be the comonotone vector with

the same marginal distributions. Setting S C = ni=1 Yi the following holds:

n
FS−1
C (x) = FX−1i (x), 0 ≤ x ≤ 1. (14.22)
i=1
A crucial result is the following:

n

FSC (m) = FXi FX−1i (FS C (m)) , m ≥ 0. (14.23)
i=1
Let (Y1 , . . . , Yn ) be the comonotone vector with the marginal distribution functions
FSt1 , . . . , FStn and S C the sum of the Yi ’s. The following inequality holds for all
n
i=1 Ki = nK:

n +

n
n
FSC (nK) = E Yi − nK ≤ E (Yi − Ki )+ = Sti (Ki ).
i=1 i=1 i=1
Using Eq. (14.23) and the relation Sti (Ki ) = exp(rti )C(F0 , 0; Ki , T ) we finally find:

n
n
exp(rti )C(F0 , 0; FS−1
ti
(FS C (nK)), T ) ≤ exp(rti )C(F0 , 0; Ki , T ).
i=1 i=1
As a consequence, the optimal choice for the call strikes in (14.21) is:
Ki = FS−1
t
(FS C (nK)).
i
Note that

n
FS−1
t
(FS C (nK)) = FS−1
C (FS C (nK)) = nK,
i
i=1
for all strictly increasing marginal cumulative distribution functions. Since the inverse
function of FS C is given by (14.22) and the right-hand side is strictly increasing in x, it
is computationally straight-forward to calculate FS C (nK). Thus this hedging strategy
is also simple to evaluate.
Numerical studies carried out in [1] for popular Lévy models and in [3] for stochas-
tic volatility models suggest that the obtained bounds become tighter the deeper the
options are in the money.
Of course the concept of comonotonicity can also be applied to other types of
options, for which the payoff depends on a sum of possibly dependent random vari-
ables, e.g., basket options. For more details we refer to [25, 49, 50]. In those papers, in
particular, the (realistic) case is considered, when there are only finitely many strikes
liquid in the market and one has to find the optimal combination of those.
This last question and especially the problem of finding a sub-replicating portfolio
(which is associated to a lower price bound for theAsian option) is also addressed in [2].
Lower price bounds on the AC price were first considered by Curran [31] and Rogers
and Shi [70], who pioneered a quite accurate method to determine lower price bounds
in the Black-Scholes model based on the following idea: Jensen’s inequality gives

n +
n +
1 1
St − K ≥ E Sti |Z − K , (14.24)
n i=1 i n i=1
where Z is an arbitrary random variable. In the Black-Scholes model the choice

n n1

Z= Si
i=1
or variants thereof are very popular (because the distribution of the geometric
mean is explicitly available in the Black-Scholes model) and leads to tight lower
price bounds, since the arithmetic and geometric average are strongly correlated
(see [31, 66, 70, 77, 80]).
However, in contrast to upper price bounds based on the concept of comono-
tonicity, this method in general does not imply a subreplication strategy. Never-
theless, in [2] it is shown that using Z = St1 together with (14.22) yields a

robust sub-replicating portfolio consisting of ni=1 e−r(T −ti ) /n calls with maturity t1
n
and strike nK/( j=1 er(tj −t1 ) ). The corresponding trading strategy is to do nothing

when S1 ≤ nK/ ni=1 er(ti −t1 ) or to buy ni=1 e−r(T −ti ) /n assets in the case that
n r(ti −t1 )
S1 > nK/ i=1 e . The cost for this trade is exactly the payoff of the options
in the portfolio plus Ke−r(T −t1 ) , which one should borrow. Then at each monitoring
time ti one should sell e−r(T −ti ) /n assets and invest the gain in the riskless bank account.
At maturity T of the Asian call, the payoff of the trading strategy is

n
1
St − K 11{ni=1 er(ti −t1 ) St1 >nK} ,
n i=1 i
which is clearly dominated by the payoff of the AC.
14.5. CASE STUDY: MODEL-DEPENDENT HEDGING

OF DISCRETELY SAMPLED OPTIONS
In Sec. 14.2 a hedging portfolio for path-independent options was presented. As the
payoff of discretely monitored options (DSO) depends only on a finite number of
monitoring times, such options can be understood as path-independent between the
monitoring times and it is possible to construct a semi-static hedging strategy with
adaptations of the portfolio only at the monitoring times. This kind of strategies was
developed by Carr and Wu [24] and Joshi [55] (see also [54]). Similar to Sec. 14.2, we
assume that standard European options are liquid for all strikes and monitoring times
of the DSO. However, to apply the techniques for the path-independent options we
need the extra assumption that the asset price process is Markovian. In particular, the
prices of standard European options may only depend on the current option price.
We consider a recursion algorithm that can be used to price such options and to
obtain some Greeks (namely the Delta and the Gamma) of the exotic option through the
corresponding ones of plain vanilla options. This algorithm is based on the assumption
that the price of the exotic option depends, in addition to the current price of the asset,
only on some summary statistic of the historic asset prices at the monitoring times
which is measurable with respect to the filtration generated by the asset price and
updated only at the monitoring times of the option. If more than one statistic is needed
to describe the price of the exotic option, the method is still feasible, but for notational
convenience we focus on the case with a single one.
As an illustrating example, an AC with strike K, monitoring times t1 , . . . , tn , and
maturity T = tn is considered, but any other similar DSOs (like e.g., cliquets, or
discretely monitored barrier and lookback options) could serve as well.
Let us denote the summary statistic of a generic DSO at time ti by Xi . Due
to the assumptions on X, Xi is Fti -measureable and Xt = Xi for ti ≤ t ≤ ti+1 ,
i = 0, 1, . . . , n − 1. Furthermore we assume that
Xi+1 = f(Xi , Sti+1 ), (14.25)
which is fulfilled for all DSOs we are aware of.
For the AC, Xi is the running average Ai of the asset prices at time ti , i.e.,
1
i
Xi := Ai = St , ∀ 1 ≤ i ≤ n.
i j=1 j
Obviously here assumption (14.25) is fulfilled, since

i 1
Ai+1 = Ai + St , ∀ 1 ≤ i ≤ n − 1.
i+1 i + 1 i+1
Due to (14.25) we have for the payoff of the generic DSO
p(ST ) = g(Xn−1 , Stn )
for some terminal payoff function g. Now, since Xn−1 is known at time tn−1 , we can
use (14.1) to find
∞
p(ST ) = g(Xn−1 , K∗ ) + gS (Xn−1 , K∗ )(S − K∗ ) + gSS (Xn−1 , x)(S − x)+ dx
K∗
K∗
+ gSS (Xn−1 , x)(x − S )+ dx, (14.26)
0
where gS and gSS denote the first and second derivative of g with respect to its second
argument. Note that, as in Sec. 14.2, the above describes a static hedge for the DSO at
the time tn−1 and therefore also its time-tn−1 -value Vtn−1 is settled.
Vtn−1 (Xtn−1 , Stn−1 ) = g(Xn−1 , K ∗ ) + gS (Xn−1 , K ∗ )(Ftn−1 − K∗ )
∞
+ gSS (Xn−1 , x)C(Stn−1 , tn−1 ; x, T )dx
K∗
K∗
+ gSS (Xn−1 , x)P(Stn−1 , tn−1 ; x, T )dx, (14.27)
0
where Ftn−1 is the time-tn−1 -forward price.

For the AC we have

+
n−1 1 1
p(ST ) = An−1 + ST − K = (ST − (nK − (n − 1)An−1 ))+
n n n
and
1
Vtn−1 (Xtn−1 , Stn−1 ) = C(Stn−1 , tn−1 ; nK − (n − 1)An−1 , T ),
n
where C(Ft , t; K, T ) := e−r(T −t) (Ft − K) for K < 0 with Ft denoting again the
forward price.
The Markov property together with (14.27) then implies that the value Vtn−1 of the
DSO at time tn−1 only depends on Xtn−1 and Stn−1 and using again (14.25) we actually
have (with a slight abuse of notation)
Vtn−1 (Xtn−1 , Stn−1 ) = Vtn−1 (Xtn−2 , Stn−1 ).
Thus we can use the right-hand side of (14.27) as the new payoff function of a (mod-
ified) DSO and iterate the procedure until we reach the current time t0 and obtain a
replicating portfolio. The associated hedging strategy is to hold this portfolio until
expiry t1 of the standard European options involved and invest the payoff of these
options to form the new replicating portfolio for the European-type option Vt2 (X1 , St2 ).
This strategy is of course self-financing.
Note that the replicating portfolio does not change until t1 , and thus one can
calculate the price of the DSO, as well as the derivatives with respect to the asset price,
with this portfolio. Unfortunately the derivatives with respect to other parameters of
the DSO price in general cannot be calculated in the same manner, since changing
those parameters would also have an effect on the portfolio.
It is worth noting that the weights of the standard options in the hedging portfolio
at the current time t0 are determined by the Gamma of the DSO at time t1 .
The derivation of this hedging strategy of course relies on the Markov assumption
on the model and the liquidity of arbitrary standard European options. However, even
if those assumptions may fail in practice, the approach gives an idea of how to obtain
approximative hedging strategies. More precisely: if neither the Markov assumption
nor the liquidity assumption is fulfilled, one might not be able to hedge the DSO
perfectly. However, if alternatively a hedging strategy is chosen in order to minimize
a certain risk measure for the hedging error in (14.26), the semi-static strategy might
still outperform classical dynamic hedging strategies. Recently, this kind of approach
was applied e.g., in [7].
14.6. CONCLUSION AND FUTURE RESEARCH
Semi-static hedging strategies can be a valuable alternative to classic dynamic replica-

tion approaches in various situations, often leading to a better performance and reduced
model risk. Although over the last years various results have been obtained, there are
many open research questions. From a theoretical perspective, it might be interesting to
extend the discussed sharp price bounds to other classes of exotic options, like cliquet
options. Also, improved price bounds in terms of other liquid options beyond standard
European options are needed. It could be rewarding to investigate which price bounds
can be obtained if American put options, variance/volatility swaps, or credit default
swaps are liquid. A recent paper in this direction is [23].
Another line of extension is to model the vanilla option prices themselves.
Recently, in [73] dynamics for option prices were found that are consistent with the
no-arbitrage assumption and one might be able to use this kind of modelling to design
more advanced trading strategies with options.
Among further future research topics is the quantitative and systematic comparison
of hedging performance of static and dynamic strategies, including historical back-
testing of the strategies.
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HEDGING IN AFFINE STOCHASTIC

VOLATILITY MODELS
15
DISCRETE-TIME VARIANCE-OPTIMAL
JAN KALLSEN∗,§ , JOHANNES MUHLE-KARBE†,¶ ,

NATALIA SHENKMAN‡, and
RICHARD VIERTHAUER∗,∗∗
∗
Mathematisches Seminar, Christian-Albrechts-Universität zu Kiel,
Christian-Albrechts-Platz 4, 24098 Kiel, Germany
†
Fakultät für Mathematik, Universität Wien, Austria
Nordbergstr. 15, 1090 Wien, Austria
‡
Lehrstuhl für Energiehandel und Finanzdienstleistungen
Universität Duisburg-Essen, Universitätsstraße 12, 45141 Essen
§
kallsen@math.uni-kiel.de
¶
johannes.muhle-karbe@univie.ac.at

natalia.shenkman@uni-due.de
∗∗
vierthauer@math.uni-kiel.de
We consider variance-optimal hedging when trading is restricted to a finite time set.

Using Laplace transform methods, we derive semi-explicit formulas for the variance-
optimal initial capital and hedging strategy in affine stochastic volatility models. For
the corresponding minimal expected-squared hedging error, we propose a closed-
form approximation as well as a simulation approach. The results are illustrated by
computing the relevant quantities in a time-changed Lévy model.
375
376 Kallsen et al.
15.1. INTRODUCTION
A classical question in Mathematical Finance is how the issuer of an option can hedge
her risk by trading in the underlying. To tackle this problem in incomplete markets,
we consider variance-optimal hedging, cf. [5, 18, 22] and the references therein for a
survey of the extensive literature. Variance-optimal hedging of a contingent claim H
means that one minimizes the expected squared hedging error
E[(v0 + ϕ • ST − H)2 ]
over all initial endowments v0 and trading strategies ϕ, where ϕ • ST represents the
cumulated gains resp. losses from trading ϕ up to the expiry date T of the claim.
In this chapter, we consider the above problem in affine stochastic volatility models.
These generalize Lévy processes by allowing for volatility clustering and are capable
of recapturing most of the stylized facts observed in stock price time series.
For Lévy processes, variance-optimal hedging has been dealt with using PDE
methods by [6] and by employing Laplace transform techniques in [4,10]. The approach
of [10] has subsequently been extended to affine models by [12,13,17] if the discounted
asset price is a martingale and by [14] in the general case. However, whereas [4, 10]
incorporate both continuous and discrete rebalancing, the results for affine processes
have focused on continuous trading thus far.
The present study complements these results by showing how to deal with discrete-
time variance-optimal hedging in affine models. Since only finitely many trades are
feasible in reality, this analysis is important in order to answer the following questions:
(1) How should discrete rebalancing affect the investment decisions of the investor,
i.e., to what extent should she adjust her hedging strategy?
(2) How can one quantify the additional risk resulting from discrete trading, i.e., by
how much does the hedging error increase?
The general structure of variance-optimal hedging in discrete time has been thoroughly
investigated by [21]. However, examples of (semi-) explicit solutions seem to be limited
to the results of [4, 10] for Lévy processes and [2] for some specific diffusion models
with stochastic volatility. Here, we show how to extend the Laplace transform approach
of [10] to general affine stochastic volatility models. Similarly as in [12, 13], we
focus on the case where the discounted asset price process is a martingale. Numerical
experiments using the results of [10] and [14] indicate that the effect of a moderate
drift rate on hedging problems is rather small.
This article is organized as follows. In Sec. 15.2, we summarize for the convenience
of the reader the general structural results of [21] on variance-optimal hedging in dis-
crete time, reduced to the case where the underlying asset is a martingale. Subsequently,
we explain how the Laplace transform approach can be used in general discrete-time
Discrete-Time Variance-Optimal Hedging 377
models in order to obtain integral representations of the objects of interest. Section 15.4
turns to the computation of the integrands from Sec. 15.3 in affine stochastic volatil-
ity models. We show how to compute all integrands in closed form for the optimal
initial capital and hedging strategy. This parallels results for continuous-time hedging
in [4, 10] and [12, 13] and for discrete-time hedging in [4, 10]. Somewhat surprisingly,
the expressions for the corresponding hedging error turn out to be considerably more
involved than in the continuous-time case and cannot be computed in closed form. We
propose two approaches to circumvent this problem: First, we determine a closed form
approximation, whose error becomes negligible as the number of trades tends to infin-
ity. As an alternative, we put forward a simple Monte–Carlo scheme to approximate
the hedging error via simulation. Section 15.5 contains some numerical examples for
the time-changed Lévy models introduced by [3].
15.2. DISCRETE-TIME VARIANCE-OPTIMAL HEDGING
Let T > 0 be a fixed time horizon, N ∈ N, T0 := {t0 , t1 , . . . , tN }, and T := T0 \{0},

where tn = nT/N for n = 0, . . . , N. Denote by (, F, (Ft )t∈T0 , P) a filtered proba-
bility space with discrete time set T0 . For simplicity, we assume that the initial σ-field
F0 is trivial. As for an introduction to financial mathematics in this discrete setup, the
reader is referred to the textbook of Lamberton and Lapeyre [15]. The logarithm X of
the discounted stock price process
S = S0 exp(Xt ), S0 ∈ R+ , t ∈ T0 ,
is supposed to be the second component of an adapted process (y, X), where X0

is normalized to zero. The first component y models stochastic volatility or, more
accurately, stochastic activity in the model. Throughout, we suppose that
E[ST2 ] < ∞,
as well as
E[St2n |Ftn−1 ] > 0, t∈T, (15.1)
to rule out degenerate cases. Our goal is to compute the variance-optimal hedge for a
given contingent claim H in the following sense.
Definition 15.1. We say that (v0 , ϕ) is an admissible endowment/strategy pair, if

v0 ∈ R and ϕ = (ϕt )t∈T is a predictable process (i.e., ϕt is Ft−1 -measurable) such that

ϕ • ST := ϕt St ∈ L2 (P).
t∈T
378 Kallsen et al.
An admissible endowment/strategy pair (v0 , ϕ ) is called variance-optimal for a

contingent claim with discounted payoff H ∈ L2 (P) at time T , if it minimizes the
expected squared hedging error
(v0 , ϕ) → E[(v0 + ϕ • ST − H)2 ]
over all admissible endowment/strategy pairs (v0 , ϕ). In this case, we refer to v0 as the
variance-optimal initial capital and call ϕ variance-optimal hedging strategy.
As noted in the introduction, we restrict ourselves to the case where the stock price
is a martingale.
Assumption 15.2. The stock price process S is a square-integrable martingale.
In this case, the variance-optimal capital and strategy can be represented as

follows.
Proposition 15.3. Let H ∈ L2 (P). Then the variance-optimal endowment/strategy

pair for H is given by
E[Vtn Stn |Ftn−1 ] − Vtn−1 Stn−1
v0 = V0 , ϕtn = , tn ∈ T ,
E[St2n |Ftn−1 ] − St2n−1
where
Vtn := E[H|Ftn ], tn ∈ T0
denotes the option price process of H. The corresponding minimal expected squared
hedging error is given by

J0 := E[VT2 − V02 ] − E[ϕtn (E[Vtn Stn |Ftn−1 ] − Vtn−1 Stn−1 )].
tn ∈T
Proof. This follows from [21, Sec. 4.1] by making use of the martingale properties of
S and V .
Notice that if the initial capital is fixed at v0 ∈ R rather than being part of the
optimization problem, the same strategy ϕ is still optimal if S is a martingale (cf. [21,
Sec. 4.1]). However, the corresponding hedging error increases by (v0 − V0 )2 in this
case.
15.3. THE LAPLACE TRANSFORM APPROACH
In order to derive formulas that can be computed in concrete models, we use the
Laplace transform approach, which has been introduced to variance-optimal hedging
by [10]. The key assumption on the contingent claim is the existence of an integral
representation in the following sense.
Assumption 15.4. Suppose that the payoff function of the claim is of the form H =
f(ST ) for some function f : (0, ∞) → R, such that
R+i∞
f(s) = sz l(z)dz,
R−i∞
for l : C → C and R ∈ R such that x → l(R + ix) is integrable and E[exp

(2RXT )] < ∞.
Example 15.5. Most European options admit an integral representation of this kind.
For example, for the European call with payoff function f(s) = (s − K)+ , we have,
R+i∞
1 K1−z
f(s) = sz dz,
2πi R−i∞ z(z − 1)
for any R > 1 by [10, Lemma 4.1]. More generally, the Bromwich inversion formula
as in [10, Theorem A.1] ascertains that l is typically given by the bilateral Laplace
transform of x → f(exp(x)), cf. [10] for more details and examples.
Henceforth, we only consider contingent claims satisfying Assumption 15.4. In

this case, Proposition 15.3 can also be written in integral form.
Theorem 15.6. We have H ∈ L2 (P) and the corresponding option price process is
given by
R+i∞
Vtn = V(z)tn l(z)dz, tn ∈ T 0 ,
R−i∞
for the square-integrable martingales
V(z)tn := E[STz |Ftn ], tn ∈ T0 .
Moreover, the variance-optimal hedging strategy for H can be represented as

R+i∞
E[V(z)tn Stn |Ftn−1 ] − V(z)tn−1 Stn−1
ϕtn = l(z)dz, tn ∈ T .
R−i∞ E[St2n |Ftn−1 ] − St2n−1
Proof. The first assertion follows from Assumption 15.4 and Fubini’s Theorem along
the lines of [13, Lemma 3.3 and Proposition 3.4]. The second can be derived analo-
gously using the Cauchy–Schwarz Inequality and E[St2n ] < ∞, tn ∈ T .
For the hedging error, Proposition 15.3 and Theorem 15.6 yield the following
similar integral representation.
380 Kallsen et al.
Corollary 15.7. For tn ∈ T and z1 , z2 ∈ R + iR, let
J1 (z1 , z2 ) := V(z1 )T V(z2 )T − V(z1 )0 V(z2 )0 ,
E[V(z1 )tn Stn |Ftn−1 ] − V(z1 )tn−1 Stn−1

J2 (tn , z1 , z2 ) :=
E[St2n |Ftn−1 ] − St2n−1
× (E[V(z2 )tn Stn |Ftn−1 ] − V(z2 )tn−1 Stn−1 ).
If, for tn ∈ T ,
∞ ∞
E[|J2 (tn , R + ix1 , R + ix2 )|]|l(R + ix1 )||l(R + ix2 )|dx1 dx2 < ∞, (15.2)
−∞ −∞
the minimal expected squared hedging error is given by

R+i∞ R+i∞
J0 = E[J1 (z1 , z2 )]l(z1 )l(z2 )dz1 dz2
R−i∞ R−i∞
R+i∞ R+i∞
− E[J2 (tn , z1 , z2 )]l(z1 )l(z2 )dz1 dz2 .
tn ∈T R−i∞ R−i∞
15.4. APPLICATION TO AFFINE STOCHASTIC

VOLATILITY MODELS
Theorem 15.6 and Corollary 15.7 show that in order to compute semi-explicit formulas
of the discrete variance-optimal capital, hedging strategy and hedging error, one must
be able to compute conditional exponential moments of the process X. This suggests to
consider models whose moment generating function E[exp(uXtn )] is known in closed
form. Here we use affine processes in the sense of [7].
Assumption 15.8. Suppose that (yt , Xt )t∈T0 is the restriction to discrete time of a
semimartingale which is regularly affine w.r.t. y in the sense of [7, Definitions 2.1
and 2.5]. This means that the characteristic function of (y, X) has exponentially affine
dependence on y, i.e., there exist mappings j : T × iR2 → C, j = 0, 1 such that,
for t ≥ s and (u1 , u2 ) ∈ iR2 ,
E[eu1 yt +u2 Xt |Fs ] = exp(0 (t − s, u1 , u2 ) + 1 (t − s, u1 , u2 )ys + u2 Xs ). (15.3)
Example 15.9. By [7, Theorems 2.7 and 2.12], a continuous-time semimartingale

(y, X) is affine if and only if its local dynamics expressed in terms of the infinitesimal
generator resp. the differential characteristics depend on y in an affine way. Moreover,
the functions 0 , 1 can be determined by solving some generalized Riccati equations.
In [11], it is shown that a large number of stochastic volatility models from the
empirical literature fit into this framework. Examples include the models of Heston [9]
and Barndorff-Nielsen and Shephard [1] as well as their extensions to time-changed
Lévy models by [3]. A particular specification of this general class of models is given
by the following OU-time-change model:
Xt = L t ys ds , dyt = −λyt dt + dZt , y0 > 0,

0
for a mean reversion speed λ > 0, a Lévy process L with Lévy exponent ψL , and an
increasing Lévy process Z with Lévy exponent ψZ , i.e.,
E[euLt ] = exp(tψL (u)), E[euZt ] = exp(tψZ (u)), ∀u ∈ iR.
In this case, (y, X) is affine by [11, Sec. 4.4] and in view of [11, Corollary 3.5], we have
1 − e−λt L
1 (t, u1 , u2 ) = e−λt u1 + ψ (u2 ),
λ
t
0 (t, u1 , u2 ) = ψ Z (1 (s, u1 , u2 ))ds.
0
If y is chosen to be a Gamma-OU process with stationary Gamma(a, b) distribution

(see [20] for more details), we have ψZ (u) = (λau)/(b − u) and 0 can be determined
in closed form as well. By [12, Proposition 3.6], we have
0 (t, u1 , u2 )

 aλ b − 1 (t, u1 , u2 )

 b log + tψ L
(u ) if bλ = ψL (u2 ),

 bλ − ψ L (u2 ) b − u1
2
=



 b
−aλ (e λt
− 1) + t if bλ = ψL (u2 ),
λu1 − ψ L (u2 )
where log denotes the distinguished logarithm in the sense of [19, Lemma 7.6], i.e.,
the branch is chosen such that the resulting function is continuous in t.
To compute exponential moments of X such as V(z)t = E[STz |Ft ], z ∈ R + iR, we

need Eq. (15.3) to remain valid on a suitable extension of iR2 . The following sufficient
condition is taken from [13].
Assumption 15.10. Suppose that for all tn ∈ T0 , the mappings (u1 , u2 ) →

j (tn , u1 , u2 ), j = 0, 1 admit analytic continuations to the strip
S := {z ∈ C2 : Re(z) ∈ (−∞, (M ∨ 0) +
) × ((2R ∧ 0) −
, (2R ∨ 2) +
)},
for some
> 0 and M := sup{21 (T − tn , 0, r) : r ∈ [R ∧ 0, R ∨ 0], tn ∈ T0 }.
382 Kallsen et al.
The existence of the analytic extensions in Assumption 15.10 is difficult to verify

in general. For affine diffusion processes, [8, Theorem 3.3] shows that it suffices to
establish that solutions to the corresponding Riccati equations exist on [0, T ]. In the
presence of jumps, the situation is more involved and one has to work on a case-by-case
basis. For time-changed Lévy processes, this has been carried out in detail by [12].
Example 15.11. By the proof of [12, Theorems 3.3, 3.4], Assumption 15.10 holds in
the OU-time-change models from Example 15.9, if the Lévy exponents ψ L and ψZ
admit analytic extensions to {z ∈ C : Re(z) ∈ ((2R ∧ 0) −
, (2R ∨ 2) +
)} resp.
{z ∈ C : Re(z) ∈ (−∞, M +
)} for some
> 0. For example, if L is chosen to be an
NIG process with Lévy exponent

ψL (u) = uµ + δ( α2 − β2 − α2 − (β + u)2 ),
for µ ∈ R, δ, α > 0, β ∈ (−α, α) in the Gamma-OU-time-change model from
Example 15.9, one easily shows that the Lévy exponents ψ Z and ψ L admit analytic
extensions to {z ∈ C : Re(z) ∈ (−∞, b)} resp. {z ∈ C : Re(z) ∈ (−α − β, α − β)}.
Consequently, checking the validity of Assumption 15.10 amounts to verifying
M < b, 2R > −α − β, 2R ∨ 2 < α − β,
for M = ((1 − e−λT )/λ)2 max{ψL (R ∧ 0), ψ L (R ∨ 0)} ≥ 0 in this case.
By [7, Theorem 2.16(ii)], Assumption 15.10 implies that the exponential moment
formula (15.3) holds for all z ∈ S. In particular, S is square-integrable. We proceed
by providing sufficient and essentially necessary conditions that ensure the validity of
the martingale Assumption 15.2 and the non-degeneracy condition (15.1).
Assumption 15.12. Assume that the martingale conditions

T T
0 , 0, 1 = 1 , 0, 1 = 0 (15.4)
N N
are satisfied and suppose that for

T T
δ0 := 0 , 0, 2 , δ1 := 1 , 0, 2 ,
N N
we have δ0 , δ1 ≥ 0 and
δ0 > 0 or δ1 yt > 0 a.s. for all t ∈ T . (15.5)
Example 15.13. For OU-time-change models, the martingale conditions (15.4) read
as ψL (1) = 0, i.e., exp(L) has to be a martingale. For example, in the NIG-OU models
from Example 15.11, this means

µ = δ( α2 − (β + 1)2 − α2 − β2 ).
As for the non-degeneracy condition (15.5), the term δ0 + δ1 y is actually bounded

away from zero in most applications.
(1) In OU-time-change models satisfying the conditions of Example 15.11,

1 (s, 0, 2) = ψL (2)(1 − exp(−λs))/λ > 0, unless L is deterministic. More-
T/N
over, we have 0 (T/N, 0, 2) = 0 ψZ (1 (s, 0, 2))ds, which is also positive
by [19, Theorem 21.5]. Since (yt )t∈T0 is bounded from below by exp(−λT )y0 > 0,
the term δ0 + δ1 y is bounded away from zero in this case. In particular, (15.5) is
satisfied.
(2) Now suppose that the Ornstein–Uhlenbeck process y is replaced by a square-root
process
√
dyt = κ(η − yt )dt + σ yt dWt , y0 > 0,
where κ, η, σ > 0 and W denotes a standard Brownian motion. Subject to certain

regularity conditions [cf. 12, Assumption 4.2], the proof of [12, Theorems 4.3,
4.4] and a comparison argument show that 1 (s, 0, 2) > 0 for s > 0. This in
t
turn yields 0 (t, 0, 2) = κη 0 1 (s, 0, 2)ds > 0 for t > 0 and hence δ0 , δ1 > 0.
Since y is positive, this shows that δ0 + δ1 y is bounded away from zero for these
CIR-time-change models as well and (15.5) holds.
From now on, Assumptions 15.10 and 15.12 are supposed to be in force. Combined
with Theorem 15.6, Assumption 15.10 allows us to compute the variance-optimal
initial capital v0 and the variance-optimal hedging strategy ϕt at time t by performing
single numerical integrations.
Theorem 15.14. For tn ∈ T0 and z ∈ R + iR, we have
V(z)tn = Stzn exp(0 (T − tn , 0, z) + 1 (T − tn , 0, z)ytn ).
Moreover, for tn ∈ T ,

R+i∞
V(z)tn−1 exp(κ0 (tn , z) + κ1 (tn , z)ytn−1 ) − 1
ϕtn = l(z)dz,
R−i∞ Stn−1 exp(δ0 + δ1 ytn−1 ) − 1
where, for j = 0, 1,

T
δ j = j , 0, 2 ,
N

T T
κj (t, z) := j , 1 (T − t, 0, z), z + 1 − j , 1 (T − t, 0, z), z .
N N
384 Kallsen et al.
Proof. The formula for V(z) follows immediately from Assumption 15.10 and [7,
Theorem 2.16(ii)]. Analogously, we obtain
E[St2n |Ftn−1 ] − St2n−1 = St2n−1 (exp(δ0 + δ1 ytn−1 ) − 1) (15.6)
and
E[V(z)tn Stn |Ftn−1 ] − V(z)tn−1 Stn−1
= V(z)tn−1 Stn−1 (exp(κ0 (tn , z) + κ1 (tn , z)ytn−1 ) − 1), (15.7)
with

T
κ0 (t, z) = 0 , 1 (T − t, 0, z), z + 1
N

T
−0 T − t + , 0, z + 0 (T − t, 0, z),
N

T T
κ1 (t, z) = 1 , 1 (T − t, 0, z), z + 1 − 1 T − t + , 0, z .
N N
By the martingale property of V(z), we have V(z)tn−1 = E[V(z)tn |Ftn−1 ]. Together

with [7, Theorem 2.16(ii)], this establishes the semiflow property
e0 (T −tn−1 ,0,z)+1 (T −tn−1 ,0,z)ytn−1
= e0 (T −tn ,0,z)+0 (T/N,1 (T −tn ,0,z),z)+1 (T/N,1 (T −tn ,0,z),z)ytn−1 ,
for tn ∈ T and z ∈ R + iR. Insertion into (15.7) yields the assertion.
We now consider the expression for the minimal expected squared hedging error
in Corollary 15.7. The first term J1 represents the variance of an unhedged exposure
to the option. In view of Assumption 15.10, it can be computed by evaluating a double
integral with the following integrand.
Lemma 15.15. For z1 , z2 ∈ R + iR, we have
E[J1 (z1 , z2 )] = V(z1 + z2 )0 − V(z1 )0 V(z2 )0 .
Proof. This is due to the martingale property of V(z1 + z2 ).

We now turn to the second term in the formula for the hedging error in Corol-
lary 15.7. Suppose for the moment that (15.2) holds. By Eqs. (15.6) and (15.7), we
have
J2 (tn , z1 , z2 ) = V(z1 )tn−1 V(z2 )tn−1
(eκ0 (tn ,z1 )+κ1 (tn ,z1 )ytn−1 − 1)(eκ0 (tn ,z2 )+κ1 (tn ,z2 )ytn−1 − 1)
× .
eδ0 +δ1 ytn−1 − 1
In view of Corollary 15.7, it therefore remains to compute
E[J2 (tn , z1 , z2 )]
= (I(κ1 (tn , z1 ) + κ1 (tn , z2 ), tn , z1 , z2 )eκ0 (tn ,z1 )+κ0 (tn ,z2 ) + I(0, tn , z1 , z2 )
− I(κ1 (tn , z2 ), tn , z1 , z2 )eκ0 (tn ,z2 ) − I(κ1 (tn , z1 ), tn , z1 , z2 )eκ0 (tn ,z1 ) )
× S0z1 +z2 e0 (T −tn−1 ,0,z1 )+0 (T −tn−1 ,0,z2 ) ,
where
I(u, tn , z1 , z2 )

e(u+1 (T −tn−1 ,0,z1 )+1 (T −tn−1 ,0,z2 ))ytn−1 +(z1 +z2 )Xtn−1
:= E .
exp(δ0 + δ1 ytn−1 ) − 1
Unfortunately, I(u, tn , z1 , z2 ) can only be computed explicitly in some very special

cases, unlike for continuous-time variance-optimal hedging. For example, if N = 1,
i.e., for static hedging, the sum in Corollary 15.7 only consists of the term J2 (T, z1 , z2 ),
which is also deterministic in this case. Hence, we obtain
(eν0 (z1 )+ν1 (z1 )y0 − 1)(eν0 (z2 )+ν1 (z2 )y0 − 1)
E[J2 (T, z1 , z2 )] = V(z1 )0 V(z2 )0 ,
e0 (T,0,2)+1 (T,0,2)y0 − 1
for νj (z) = j (T, 0, z + 1) − j (T, 0, z), j = 0, 1, which allows to compute the static
hedging error by evaluating a double integral.
For Lévy processes, we have δ1 = 0. Hence the denominator in the expression
for I reduces to a constant in this case and the expectations can be computed using
(15.3). This leads to the formula obtained in [10].
For affine models, one can verify that as the number of trading times N tends
to infinity, the argument of the expectation in the expression for I converges to an
386 Kallsen et al.
expression of the form

a + bytn−1
exp(uytn−1 + (z1 + z2 )Xtn−1 ).
c + dytn−1
The expectation of this term can then be calculated, cf. the proof of [13, Theorem
4.2] for more details.
If the set of trading times is finite, it does not seem possible to calculate I in closed
form. We discuss two ways to circumvent this problem and tackle the computation of
the hedging error. The first is to use the approximation
exp(δ0 + δ1 yt ) − 1 ≈ δ0 + δ1 yt ,
which seems reasonable as the number N of trading dates tends to infinity, because
both δ0 = 0 (T/N, 0, 2) and δ1 = 1 (T/N, 0, 2) converge to zero in this case. We
obtain the following first-order approximation.
Theorem 15.16. Suppose that for any t ∈ T0 , the following holds.
(1) The mappings (u1 , u2 ) → j (T −t, u1 , u2 ), j = 0, 1 admit analytic extensions to
S := {z ∈ C2 : Re(z) ∈ (−∞, (M ∨ 0) +
) × ((2R ∧ 0) −
, (2R ∨ 2) +
)},
for some
> 0 and M := M ∨ 21 (T/N, M/2, R + 1).
(2)

exp(M yt + 2RXt )
E < ∞. (15.8)
δ0 + δ1 yt
Then (15.2) is satisfied and for n = 1, . . . , N, z1 , z2 ∈ R + iR,
u ∈ 1 (T − tn−1 , 0, z1 ) + 1 (T − tn−1 , 0, z2 )
+ {κ1 (tn , z1 ) + κ1 (tn , z2 ), κ1 (tn , z1 ), κ1 (tn , z2 ), 0},
we have

exp(uytn−1 + (z1 + z2 )Xtn−1 )
E
δ0 + δ1 ytn−1
 −uδ0 /δ1 1

 e δ1 δ0

 + us exp us + χ0 (s) + χ1 (s)y0 ds if δ0 , δ1 = 0,

 δ1 δ0 δ1


0


 1
= 1 1 + us
 exp(ϑ0 (s) + ϑ1 (s)y0 )ds if δ0 = 0,

 δ1 0 s





 1

 exp(0 (tn−1 , u, z1 + z2 ) + 1 (tn−1 , u, z1 + z2 )y0 ) if δ1 = 0,
δ0
where, for j = 0, 1,

T δ1
δ j = j , 0, 2 , χj (s) := j tn−1 , log(s) + us, z1 + z2 ,
N δ0
ϑj (s) := j (tn−1 , log(s) + us, z1 + z2 ).
Proof. In view of (15.5), we have exp(δ0 + δ1 yt ) − 1 > δ0 + δ1 yt , which combined

with (15.6) yields

1 E[V(z1 )tn Stn |Ftn−1 ] − V(z1 )tn−1 Stn−1
E[|J2 (tn , z1 , z2 )|] <
δ0 + δ1 ytn−1 Stn−1

E[V(z2 )tn Stn |Ftn−1 ] − V(z2 )tn−1 Stn−1

× . (15.9)
S
tn−1
By Assumption 15.10, [7, Theorem 2.16(ii)] and Jensen’s Inequality, we have

V(zj )tn−1 Stn−1
≤ S R e0 (T −tn−1 ,0,R)+1 (T −tn−1 ,0,R)ytn−1 +RXtn−1
Stn−1 0

≤ S0R e0 (T −tn−1 ,0,R) e 2 M ytn−1 +RXtn−1 ,
1
for j = 1, 2. Likewise, it follows from Jensen’s Inequality that, for j = 1, 2,

E[V(zj )tn Stn |Ftn−1 ]

S
tn−1
≤ E[|V(zj )tn |Stn |Ftn−1 ]S0−1 e−Xtn−1
≤ S0R E[e0 (T −tn ,0,R)+1 (T −tn ,0,R)ytn +(R+1)Xtn |Ftn−1 ]e−Xtn−1
≤ S0R e0 (T −tn ,0,R) E[e 2 Mytn +(R+1)Xtn |Ftn−1 ]e−Xtn−1

1
= S0R e0 (T −tn ,0,R) e0 (T/N,M/2,R+1)+1 (T/N,M/2,R+1)ytn−1 +RXtn−1

≤ S0R e0 (T −tn ,0,R)+0 (T/N,M/2,R+1) e 2 M ytn−1 +RXtn−1 ,
1
where we have used Assumption 15.10 and [7, Theorem 2.16(ii)] for the equality.
Together with (15.9), this implies
exp(M ytn−1 + 2RXtn−1 )
|J2 (tn , z1 , z2 )| ≤ C ,
δ0 + δ1 ytn−1
for some constant C > 0 which does not depend on ω and z1 , z2 . Consequently, (15.8)
and Assumption 15.4 yield (15.2). The second part of the assertion now follows along
the lines of the proof of [13, Theorem 4.2] under the stated assumptions.
388 Kallsen et al.
Example 15.17. In most applications the denominator in (15.8) is actually bounded

away from zero (cf. Example 15.13). In this situation, (15.8) follows immediately from
Condition 1 of Theorem 15.16 and [7, Theorem 2.16(ii)].
In view of Theorem 15.16, the hedging error can be approximated by a sum of

triple integrals with known integrands. Notice that because
1 1 1
= − ,
δ0 + δ1 yt + 1
(δ
2 0
+ δ 1 yt )2 δ0 + δ1 yt δ 0 + 2 + δ1 y t
a second-order approximation based on
1
exp(δ0 + δ1 yt ) − 1 ≈ δ0 + δ1 yt + (δ0 + δ1 yt )2
2
follows directly from Theorem 15.16.
Instead of using the closed-form approximation proposed above, one can
eschew semi-explicit computations and instead calculate the hedging error using a
Monte–Carlo simulation as in [6]:
(1) Simulate K ∈ N independent trajectories (y(ωk ), X(ωk )), k = 1, . . . , K of (y, X)

and compute the realizations S(ωk ) = S0 exp(X(ωk )) and H = f(ST (ωk )) of S
and H.
(2) Calculate the values of v0 and ϕtn (ωk ), tn ∈ T using numerical integration to
evaluate the formulas from Theorem 15.14.
(3) Compute the realized squared hedging errors
 2

J0 (ωk ) = v0 + ϕtn (ωk )Stn (ωk ) − f(ST (ωk )) .
tn ∈T
1 K
(4) Use the empirical mean K k=1 J0 (ωk ) as an estimator for J0 .
In addition to its simplicity, this approach has the advantage of approximating the
entire distribution of the hedging error, rather than just its mean. On the other hand,
computation time is increased.
15.5. NUMERICAL ILLUSTRATION
In order to illustrate the applicability of our formulas and examine the effect of discrete
trading, we now investigate a numerical example. More specifically, we consider the
NIG-Gamma-OU model from Examples 15.9 and 15.11. As for parameters, we use the
values estimated in [16] using the generalized method of moments, adjusting the drift
rate µ of L in order to ensure the martingale property of S:
β = −16.0, α = 90.1, δ = 85.9, µ = 15.0,
λ = 2.54, a = 0.847, b = 17.5.
By Example 15.11, Assumption 15.10 and the prerequisites of Theorem 15.16 are
satisfied for European call options and R = 1.1. Henceforth, we consider a European
call with discounted strike K = 100 and maturity T = 0.25 years. The results for
the variance-optimal initial hedge ratio ϕ0 for N = 1 (static hedging) and N = 12
(weekly rebalancing) are shown in Figs 15.1 and 15.2.
For static hedging, the impact of discretization seems to be quite pronounced,
in particular for out-of-the-money options. Also notice that this effect turns out
to be substantially bigger for the NIG-Gamma-OU than for the Black–Scholes
model. For weekly rebalancing, the effect of discretization on the initial hedge ratio
already becomes marginal. More specifically, the difference between the discrete- and
continuous-time variance-optimal hedging strategies is barely visible in Fig. 15.2.
Figure 15.3 shows a simulated path of the discrete variance-optimal hedges for
N = 1, 3, 12, 60.
Figure 15.1 Variance-optimal initial hedge ratios for N = 1.

390 Kallsen et al.
Figure 15.2 Variance-optimal initial hedge ratios for N = 12.
Hedging strategy (Strike = 100, T = 0.25, N = 1, 3, 12, 60 )

1
0.9
0.8
0.7
0.6
Hedge ratio
0.5
0.4
0.3
0.2
N=1
0.1 N=3
N=12
N=60
0
0 0.05 0.1 0.15 0.2 0.25
Time
Figure 15.3 A simulated path of optimal hedge ratios for N = 1, 3, 12, 60.
We now turn to the minimal expected squared hedging error, which is depicted
for N = 1 (static hedging) to N = 60 (daily rebalancing) in Fig. 15.4. As the number
N of trading dates tends to infinity, the discrete hedging errors approach the respective
continuous-time limits both in the Black–Scholes model and in the NIG-Gamma-OU
model. Naturally, this limit vanishes in the complete Black–Scholes model. As noticed
above, the static hedging error for N = 1 can be computed without using any approx-
imations. For N ≥ 2, the discrete-time hedging error in the given NIG-Gamma-OU
model is approximated surprisingly well by the sum of the respective continuous-
time hedging error and the corresponding discrete-time hedging error in the Black–
Scholes model. In fact, the maximal absolute difference is smaller than 0.045. If such
an approximation can be used for the specific model at hand, computation time can
often be drastically reduced by evaluating the formulas from [10, 12] instead of The-
orem 15.16.
Note that the discrete hedging errors in the NIG-Gamma-OU model have been
approximated using Theorem 15.16. Since the corresponding results for a simulation
study using one million Monte–Carlo runs differ by less than 2.5% for N = 1, . . . , 60,
we do not show them here. However, in Fig. 15.5, we use the results of the Monte–
Carlo study to depict an approximation of the distribution of the hedging error for
Figure 15.4 Minimal expected squared hedging errors.

392 Kallsen et al.
Figure 15.5 Approximated distribution of the hedging error for N = 1, 12, 60.
N = 1, N = 12, and N = 60. Apparently, not only the variance of the hedging error,
but also its law depend crucially on the rebalancing frequency.
Acknowledgments
The first and fourth authors gratefully acknowledge financial support through Sach-
beihilfe KA 1682/2-1 of the Deutsche Forschungsgemeinschaft.
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-arbitrage approach. Operations Research, 49, 372–397.
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May 12, 2010 18:8 WSPC/SPI-B913 b913-Index FA
INDEX
absolute ambiguity robust adjustment calendar spread option, 118, 119

(AARA), 330 capital-market scenarios, 149, 170
affine process, 376, 380 CCO, 177
alternative asset classes, 52 CDS/credit default swaps, 259–261,
Alternative real assets, 51–54, 69 265–267, 270, 271, 283, 285–290
ambiguity, 327–337, 339–344 CDX, 261, 266, 272, 275–277, 285, 289,
ambiguity robust adjustment (AARA), 330, 290, 292
333 CFXO, 177
ambiguity robust adjustment (RARA), 330 CIR-time-change model, 383
Angström-type equation, 58 closed-end funds, 52
asset allocation, 147–149, 162, 165, 168, cointegration, 84–86
170, 171 collateralized asset obligation, 179
asset class, 3, 4, 8–13, 17–19 collateralized commodity obligation, 177
Autocorrelation, 65, 66 collateralized debt obligation, 176
aviation, 53 collateralized fx obligation, 177
collateralized trigger swap obligations, 177
backtesting, 88 comonotone random vector, 365
barrier options, 345, 347, 350, 352–355, conditional value at risk optimization/CVaR
359, 361–364 optimization, 147, 157, 164–169, 171
Black–Litterman expectation, 9, 10, 17 confidence ellipsoid, 317, 319
Black-76, 98, 105, 114, 116, 117 constant proportion portfolio insurance
Bonus (Guarantee) Certificates, 134 (CPPI), 227, 228, 232
borrowing constraints, 227, 230 copula approach, 186, 187, 189, 190, 193
bottom-up approach, 52, 54, 55, 68 corporate bonds, 148, 158, 160, 162, 163,
Brownian motion, 263, 264, 271, 272, 275, 165, 166, 170
277, 285, 290 correlated default times, 147, 150, 152, 158
395
396 Index
CPDO/constant porportion debt obligation, freight futures, 71, 78, 79, 81, 86
259–261, 285–292 freight rates, 74, 75, 77, 80–82, 90
CPPI, 201–203, 205–207, 209–211,
213–224 Gamma distribution, 271
CPPI strategies, 295, 296, 300, 304, 305, Gamma-OU process, 381
311, 321, 323, 324 gap risk, 229, 230, 241, 246, 247, 251, 259,
CPPI/constant proportion portfolio 268, 270, 277–279, 281–284, 287, 292
insurance, 259–261, 267–270, 275, 278, Global irradiance, 53, 55–58, 60–62
281, 282, 284, 285, 289, 291, 292 granger causality, 82, 83
Credit default swap index/CDS index, 154, guarantees, 228–230, 242
155, 157, 161, 169
Credit default swap/CDS, 148, 149, Heath–Jarrow–Morton, 94
153–155, 157, 158, 160–163, 165, 169, Hull-White model, 56
170
CreditGrades, 125 index certificates, 124, 126, 135
cross asset portfolio derivatives, 175–177, inflation, 51–53, 55–57, 65
182, 191, 195 inflation protection, 52, 53, 55
cushion, 267–269, 275, 277, 282, 284, 305, infrastructure, 51–53
307 issuer risk, 123–125, 130, 132, 139
iTraxx, 261, 266, 272, 275–277, 285, 289,
default risk, 123 290, 292
defaultable knock-out put options, 126
discount certificates, 126 Jensen’s Inequality, 107–110
discretely sample options, 347, 362, 367
dynamic asset allocation, 296 Lévy process, 264
dynamic portfolio insurance, 201 Laplace transform approach, 376, 378
leverage, 261, 267, 268, 275, 285–288, 290,
Economic Scenario Generator, 56 291
efficient portfolios, 295, 296, 299, 300, 312, LIBOR model, 98
313, 316, 324, 325 limited partnership fund, 51, 53
estimation risk, 295, 296, 298, 313, 314, log-normal (shifted), 126
316, 320, 321, 324, 325 lookback options, 346, 347, 364, 368
ETF, 201, 203, 210, 223, 224
European options, 348, 349, 355, 357, 358, Macroeconomic factors, 56, 57
361, 363, 367, 369, 370 Margrabe Formula, 117
(extended) roll-down call, 362 Markov-Switching model, 3, 4, 11, 12, 19
expected shortfall, 308, 309, 312 Markov transition matrix, 4, 6, 7
expected-squared hedging error, 375 maximum Sharpe ratio portfolio, 299, 301,
explanatory variables, 72, 79–82, 312, 314, 316, 321, 322
84–86, 90 mean-variance optimization, 299, 300, 310,
exposure, 303, 305, 307 311
extreme value theory (EVT), 282 method of moments, 11
minimum variance portfolio, 299, 301, 312,
floor, 303, 305, 307–309 316, 320, 322–324
forward freight agreement, 77, 78 model-independent strategies, 359
freight derivatives, 71, 77, 78 Monte Carlo simulation, 13
Index 397
multi-asset portfolio, 51, 52, 68 static hedging, 385, 389, 391

multiplier, 305–313, 315, 316, 320–324 static hedging strategies, 362, 370
multivariate variance gamma model, 289 stop-loss transform, 365
strong path-dependence, 347
NIG process, 382 structural approach, 185, 186, 188, 192, 193
Normal-inverse gaussian one-factor sub-replication (sub replicating strategies),
copula/NIG one-factor copula, 147, 149, 354, 359
152, 171 subjective expected utility (SEU), 328
nth-to-trigger basket, 177, 178, 183 super-replication (super replicating
strategies), 359, 361, 362, 365
oil, 72–74, 76, 77, 81–84, 86 sustainability, 3, 4, 6–8, 18
option-based portfolio insurance (OBPI), sustainability score, 6, 7, 18
228, 232 swaptions, 270, 273–275, 279, 280
OU time-change model, 382, 383
Term structure of interest rates, 57
Participation Guarantee Certificates, 132 TIPP, 203, 214, 220
path-independent payoff, 347 total variance, 66
photovoltaic, 51–56, 58, 61–64, 66–69 trading route, 73, 78
Portfolio, 51, 52, 56, 63–69 transaction costs, 227, 230, 242, 246, 247,
portfolio insurance, 259, 267 249–251
portfolio optimization, 13, 149, 156, 160, trigger derivative, 176, 178, 179, 188, 195
162, 171, 231
power forward, 93–96, 98–103, 107, 108, uncertainty set, 317–320
110–120 utility, 227–230, 232–234, 240–244, 246,
power markets, 93, 94, 96, 97 250
Put-Call-Parity, 346, 349, 352, 360 functions, 232, 233, 237, 242
loss, 230, 243–245, 250, 251
ratchet call, 363
real return, 53 variance gamma process, 264, 270, 274
renewable energy, 51–53 variance-optimal hedging strategy, 378, 379,
robust counterpart, 295, 316, 317, 320 383
robust mean-variance optimization, 316 variance-optimal initial capital, 375, 378,
383
Samuelson effect, 97, 100 Vasicek process, 56
semi-static hedging strategies, 345, 352, 370 vector auto regression model, 72, 79, 80
shipping, 51–54 vessel, cargo, 72
Shipping market, 72, 75, 80 vulnerable options, 124
shortfall probability, 250, 251, 308, 309,
311, 312, 316, 322, 324 weak (strong) path-dependence, 347, 350,
socially responsible investing (SRI), 3, 4 364
solar plants, 51, 53, 54 wind power plants, 53

Alternative Investments and Strategies

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Library of Congress Cataloging-in-Publication Data

British Library Cataloguing-in-Publication Data

Copyright © 2010 by World Scientific Publishing Co. Pte. Ltd.

Typeset by Stallion Press

Juliet - Alternative Investments.pmd 1 8/2/2010, 6:18 PM

R. Kiesel, M. Scherer, and R. Zagst

Part I. Alternative Investments

Chapter 2. Listed Private Equity in a Portfolio Context 21

2.2.3 Type of Financing . . . . . . . . . . . . . . . . . . . . . . . . . 25

Chapter 3. Alternative Real Assets in a Portfolio Context 51

3.3.3 Modeling of Risk Factors . . . . . . . . . . . . . . . . . . . . . 56

Chapter 4. The Freight Market and Its Derivatives 71

Chapter 5. On Forward Price Modeling in Power Markets 93

5.3.1 A Geometric Brownian Motion Dynamics

Chapter 6. Pricing Certificates Under Issuer Risk 123

Chapter 7. Asset Allocation with Credit Instruments 147

Chapter 8. Cross Asset Portfolio Derivatives 175

8.1 Introduction to Cross Asset Portfolio Derivatives . . . . . . . . . . . . . 175

Part II. Alternative Strategies

9.4.4 Leverage and Constrain of Exposure . . . . . . . . . . . . . . . 212

Chapter 10. How Good are Portfolio Insurance Strategies? 227

11.4 Modeling of CPPI Dynamics Using Multivariate

12.4.3 Uncertainty Sets Via Confidence Sets . . . . . . . . . . . . . . . 319

Chapter 13. Robust Asset Allocation Under Model Risk 327

Chapter 14. Semi-Static Hedging Strategies for Exotic Options 345

Chapter 15. Discrete-Time Variance-Optimal Hedging in Affine

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Socially Responsible Investments 5

1.2. RECENT RESEARCH ON SRI

1.3. HOW SUSTAINABLE IS SUSTAINABILITY?

In this section, the endurance of sustainability is analyzed. This is especially important

1.3.1. Description of the Dataset

1.3.2. Introduction to Markov Transition Matrices

Table 1.1 Statistics on Total Score.

Socially Responsible Investments 7

1.3.3. Results of Markov Transition Matrices

Table 1.2 Average One-Year Markov Transition Proba-

Next year quartile

1 (%) 2 (%) 3 (%) 4 (%)

1 69.74 25.00 4.90 0.37

Table 1.3 Markov Six-Year Transition Probabilities

Next year quartile

1 46.43 26.79 21.43 5.36

1.4. SRI IN PORTFOLIO CONTEXT

1.4.1. Description of the Dataset and Statistical Properties

Socially Responsible Investments 9

Table 1.4 Empirical Statistics of Daily Log-Returns.

Empirical statistics Bonds Stocks SRI

Mean 0.00024 0.00026 0.00038

Table 1.5 Black–Litterman Expectations for Asset Class

Black–Litterman expectations Bonds Stocks SRI

Daily return 0.00018 0.00029 0.00041

Table 1.6 P-Values of Jarque–Bera and Ljung–Box-Q Tests.

Test Null hypothesis Bonds Stocks SRI

Jarque–Bera Normal distribution <0.001 <0.001 <0.001

Table 1.7 Empirical Correlations of Daily

Correlation Bonds Stocks SRI

Bonds 1 −0.034524 0.044066

Socially Responsible Investments 11

1.4.2. Markov-Switching Model