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Principles of Financial Engineering, 3rd Edition by Salih N. Neftci, Robert Kosowski

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Chapter 23

Principal Protection Techniques

In earlier chapters, we discussed option-based hedging techniques such as the purchase of put options and synthetic put options based on replication. In this chapter, we show that there are other techniques that involve dynamic portfolio rebalancing which can also serve the purpose of principal protection. The best-known dynamic rebalancing technique is called constant proportion portfolio insurance (CPPI). The CPPI approach invests only a part of the capital in a risky asset and the remainder in a safe way. We outline the theory behind CPPI and provide numerical and real-world examples. We show how CPPI can be applied to credit derivatives such as iTraxx equity tranches. We discuss extensions of CPPI ...

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