Theory of Performance Participation Strategies

TL;DR

This paper introduces and compares two innovative performance participation strategies, OBPP and CPPP, which address limitations of traditional portfolio insurance methods by allowing participation in risky assets with controlled guarantees.

Contribution

It generalizes portfolio insurance strategies to include performance-based guarantees, providing analytical expressions and dynamic hedging analysis for the new methods.

Findings

OBPP and CPPP effectively mitigate cash lock-in issues during market crises.

Analytical formulas for all moments of the strategies are derived.

Dynamic hedging properties, including delta hedging, are analyzed.

Abstract

The purpose of this article is to introduce, analyze and compare two performance participation methods based on a portfolio consisting of two risky assets: Option-Based Performance Participation (OBPP) and Constant Proportion Performance Participation (CPPP). By generalizing the provided guarantee to a participation in the performance of a second risky underlying, the new strategies allow to cope with well-known problems associated with standard portfolio insurance methods, like e.g. the CPPI cash lock-in. This is especially an issue in times of market crisis. However, the minimum guaranteed portfolio value at the end of the investment horizon is not deterministic anymore, but subject to systematic risk instead. With respect to the comparison of the two strategies, various criteria are applied such as comparison of terminal payoffs and payoff distributions. General analytical expressions for all moments of both performance participation strategies as well as standard OBPI and CPPI are derived. Furthermore, dynamic hedging properties are examined, in particular classical delta hedging.