This report and others are available online at Nomura's new research website.

To obtain a
user id and password, please contact Diana Berezina at [email protected].
The web address is http://www.nomura.com/research/s16
Please read the important disclosures and analyst certifications
appearing on the second to last page.

September 8, 2005

Contacts:
Michiko Whetten
(212) 667-2338
[email protected]

Weimin Jin, Ph.D.
(212) 667-9679
[email protected]

Nomura Securities International, Inc.
Two World Financial Center
New York, NY 10281-1198
www.nomura.com/research/s16
Anatomy of Credit CPPI
I. Introduction
Although the global credit market environment remains relatively benign, the structured credit market
has recently turned away from structures that aggressively seek incremental yields, such as CDOs-
squared, toward structures of a more defensive nature. The new defensive structures, including
constant-maturity CDS (CMCDS), long-short synthetic CDOs, and principal-protected credit-linked
notes based on constant proportion portfolio insurance (CPPI), provide a certain degree of protection
against risks such as spread widening and idiosyncratic defaults. In this paper, we introduce the
basic features of credit-based CPPI and identify some of the factors that affect its performance.
II. The CPPI Basics
The constant proportion portfolio insurance (CPPI) was first introduced by Fisher Black and Robert
Jones in 1986.
1
The method provides a form of dynamic hedging for a portfolio, and has been
employed extensively in the hedge fund space. More recently, however, the credit-linked CPPI
approach has become popular as a way to create principal-protected credit-linked notes. While not
all the strategies and products in the market place strictly adhere to the analytics of the traditional
CPPI, they all use some form of a dynamic asset allocation to protect principal yet provide the
potential for substantial upside in returns.
The basic premise of CPPI is fairly simple. We start with a portfolio, for which an investor hopes to
receive principal protection of, say, $100. The investor shifts asset allocation between the risk-free
asset and risky assets over his investment horizon. At any point in time, he would like to have just
enough money to buy a risk-free bond that will become $100 at maturity. This amount is called the
"bond floor," and tends to increase as maturity approaches.
The difference between the initial investment and the bond floor is often called the "cushion."
2
This
amount is invested in risky assets, such as stocks, hedge funds, or credit products, often in a
leveraged format. This degree of leverage is set by the "gearing factor," which remains constant over
the investment horizon, thus giving rise to the name "constant proportion."
3
The risky exposure is
also subject to some borrowing constraints, so the overall leverage is often limited to a certain level.
Depending on the performance of the risky exposure, the investor dynamically adjusts the allocation
between the risky and the risk-free assets.

1
Black, F., and R. Jones, "Simplifying Portfolio Insurance," Journal of Portfolio Management (1987).
2
Other terms may also be used; it is sometimes called "trading equity" in the hedge fund context, or reserve in
the credit CPPI arena.
3
However, some new structures utilize dynamic leverage instead of constant leverage.
Nomura Fixed Income Research
Nomura Fixed Income Research
(2)
Obviously, the higher the leverage is, the higher potential upside would be. However, high leverage
increases the risk that the value of the risky exposure declines too fast for the investor to readjust his
asset allocation. Indeed, the portfolio value could fall below the bond floor, albeit with a relatively low
probability. Hence, the strategy is not a "locked-in" hedge, and the name "insurance" does not
describe its nature precisely.
In contrast, a static portfolio hedge refers to a strategy that calls for initially investing a portion of the
portfolio in the risk-free, zero-coupon bond to ensure that the desired amount is available at maturity
for certain.
4
The static approach is equivalent to purchasing a European put option on the portfolio.
However, it may be more costly when the risk-free interest rate is relatively low, because the
relatively high bond floor limits the amount that can be invested in risky, higher yielding assets.
Many credit CPPIs take a hybrid format. In a credit CPPI, the main sources of risk are default losses
and spread widening, which lowers the value of the risky exposure. This risk can be sourced in a
"unfunded" CDS form, which allows large leverage. Alternatively, the risk can be sourced in a single-
tranche CDO, such as the equity tranche of the CDS index. While the risk-free portion of the portfolio
earns the risk-free return, the credit portion earns collateral return plus protection premium (i.e.,
spread) based on the notional amount of credit exposure.
III. A CPPI Example Shifting Asset Allocation
As an illustration, let us start with a portfolio of $100, with an investment horizon of 10 years. We
want to have the principal of the initial investment protected, so we calculate the "bond floor" as the
value of a risk-free bond that matures at the end of the investment horizon. We also set the constant
multiple for the risky exposure at 4x. For simplicity, the maximum leverage on the risky exposure
allowed is assumed to be constant and 1x the current portfolio value.
5

The table in the following page shows how the portfolio allocation is adjusted according to the
performance of the risky credit exposure. The goal here is to get highly leveraged returns while
maintaining an adequate amount to buy the zero-coupon bond, which pays $100 at maturity.
Suppose the risky exposure is a leveraged credit risk portfolio, which pays a 10% protection premium
on the average notional amount annually. The risk-free yield is assumed to be 2% per annum. We
also assume zero coupon payout (i.e., all spread is reinvested) until the maturity of the investment.
The amount of risky credit exposure is frequently adjusted according to two constraints; (1) the
constant leverage on the amount of the "cushion," and (2) the overall leverage limit.
6
The bond floor
is $82.0 initially at a risk-free rate of 2%, so the cushion is $18.0 (= $100 82.0). Hence, the amount
of the cushion multiplied by the gearing factor, or $72 (=$18 x 4) is allocated to the leveraged credit
risk exposure, while the rest (= $28) is invested in the risk-free asset.
At the end of Year 1, the credit exposure receives a 10% premium, increasing the value of the credit
portfolio to $79.2. The aggregate portfolio value increases to $109.2 (= $79.2 + 28.0 + 2.0). With the
bond floor of $83.7, the cushion is now $25.5. The allowed exposure increases to $102.0, so an
additional $22.8 is allocated to the credit portfolio. The risk-free exposure is now $7.2 (= 109.2
102.0).

4
See; R. Bookstaber and J. Langsam, Portfolio Insurance Trading Rule, The Journal of Futures Markets, Vol. 20,
No. 1, 41-57 (2000).
5
The maximum leverage may be dynamically adjusted and can be defined in one of many forms. For example, it
may be calculated as the ratio of the current value of risky exposure divided by the size of possible overnight
mark-to-market loss, so that the structure can withstand such a shock without losing the principal protection.
6
These constraints are written as:
Risky exposure = min [max[m(V bond floor), 0], l(V)]
where m, l, and V are the gearing factor, the leverage limit, and the current portfolio value, respectively
Nomura Fixed Income Research
(3)
At the end of Year 2, the credit portfolio pays $10.2 in coupon on the notional amount of $102.0. The
portfolio value is now $121.6 (= 112.2 + 7.2 + 2.2). The bond floor goes up to $85.4, so the cushion
is $36.2 (= $121.6 85.4). The allowed risky exposure is calculated to be $144.7, but the maximum
leverage is 1x the portfolio value, so the portfolio, valued at $121.6 is now 100% risky credit
exposure.

Table 1: CPPI Portfolio Allocation
Time Bond
floor
Default
loss
Credit risk
portfolio
Overall
portfolio
Cushion Allowed
exposure
Purchase/sale
of credit risk
Risk-free
asset
0 82.0 100.0 18.0 72.0 + 72.0 28.0
1 83.7 0% 79.2 109.2 25.5 102.0 + 22.8 7.2
2 85.4 0% 112.2 121.6 36.2 121.6 + 9.4 0.0
3 87.1 20% 109.5 111.9 24.8 99.2 - 10.3 12.7
4 88.8 0% 109.1 124.1 35.3 124.1 + 15.0 0.0
5 ... ... ... ... ... ... ... ...
Suppose that, at the end of Year 3, the credit portfolio experiences default loss of 20%, or $24.2. The
risky notional amount declines from $121.6 to $97.3. The spread paid on the credit portfolio is $12.2,
based on the previous notional of $121.6. The portfolios end value is $111.9 (= $97.3 + 12.2 + 2.4).
This results in a smaller cushion of just $24.8 and, hence, a lower credit exposure of $99.2. The
notional amount of the risky credit exposure decreases by $10.3.
At the end of Year 4, no additional default has occurred, and the credit portfolio yields $9.9 in spread
on the notional amount of $99.2. The new portfolio value is $124.1 (= $109.1 + 12.7 + 2.2). The
cushion goes back up to $35.3 (= $124.1 88.8), and the credit exposure once again increases to
100%. This requires reallocation of $15.0 to the credit portfolio.
The adjustment of the risky credit exposure continues over the investment horizon. If the
performance of the credit portfolio is favorable, the allocation to the risky portfolio could reach the
maximum level, or, in this example, 100% of the portfolio value. On the other hand, if the
performance is poor, the entire portfolio may be allocated to the risk-free bond, a situation called a
close-out, allowing no more risky exposure. The gist of the CPPI is to maintain highly leveraged
exposure in such a way that a sufficient amount is available to assure principal protection, while
maximizing the return from the risky exposure. To this end, the leveraged risky exposure expands
and contracts in sync with the performance of the risky asset.
The example above assumed that spreads received on the risky credit portfolio are reinvested. In
such a case, the portfolio value keeps growing and the credit exposure expands, unless there are
default losses. In contrast, if most of the spreads are paid out to the investor, the portfolio value and
the risky exposure tend to remain flat. Hence, the terminal value and the internal rate of return (IRR)
of the investment could vary significantly depending on whether the periodic coupon is paid to the
holder of the CPPI note.
7

Also, the above example assumed that the portfolio is readjusted on spread payments and default
losses, but not on mark-to-market changes of the portfolio value. In reality, many CPPI structures
readjust allocation based on the portfolio value including the mark-to-market gains/losses, hence
incorporating the "spread risk" of the credit portfolio.

7
In the example shown, if the investor receives all of the periodic spreads, the portfolio performance would be
dramatically different. More specifically, the portfolio value would not increase, and the cushion gradually declines
as the bond floor increases over time. As a result, the available protection premium from the credit portfolio would
also drop over time.
Nomura Fixed Income Research
(4)
IV. Credit-Linked CPPI Variations
In the past, the CPPI technique was more commonly used in the hedge fund/equity market context.
Recently, however, products using CPPI in the context of credit risk have begun to appear.
8
Credit-
linked notes referencing the tranches of the CDS index, such as iTraxx Europe, are now very popular.
Moreover, an actively managed portfolio of CDS and corporate bonds, rather than the CDX indices,
can also be used to source risk. Some programs combine the CPPI mechanism with constant-
maturity CDS (CMCDS), as a defensive strategy against general spread widening. Another possible
variation may be adding some up-side potential based on the stock market or an equity tranche of
synthetic CDOs. Some programs include an "explicit" principal guarantee by the sponsor, while
others provide an implicit protection (i.e., "protective mechanism") where the investor is exposed to
possible losses of principal. The following table summarizes some of credit CPPI structures:

Table 2: Evolution of Credit-linked CPPI
(Selected programs, announced or priced)
Reference credit Date Description Series / Sponsor
CDS index
November
2003
MTNs with a CPPI structure.
Dynamic
Participation Notes /
ABN AMRO
CDS index Early 2004
Fixed coupon, with upside potential on the
performance of the European CDS index.
Rente Booster /
ABN AMRO
CDS index Early 2005
Linked to the iTraxx index. Geared for institutional
and retail investors.
Credit Sail / Calyon
CDS long/short April 2005
Managed CDS portfolio with long equity, short
mezzanine structure, where manager controls jump-
to-default risk.
Cairn Capital CPPI /
CSFB
Managed CDS
portfolio - equity
March
2005
Principal-protected note with CMCDS coupon. The
default risk of the equity (0%-3%) tranche determines
the notional amount.
Topaz / Deustche;
Cars / UBS
Managed CDS
portfolio IG, HY,
EM
June 2005
Principal-protected on an actively managed portfolio
of HY, IG, and EM credits both in CDS and cash bond
formats. The manager can trade with no limits,
including short positions.
Dynamo / BNP
Paribas; Credit
Agricole
Managed CDS
March
2005
Linked to a managed basket of 100-150 credits.
Patrimoin Obligation
Croissance (POC) /
Axa
Managed CDS
portfolio
April 2005
Principal-protected note with upside potential based
on the managed portfolio.
Axa Synergie / ABN
AMRO
Dynamically
leveraged, CDS
index
July 2005
Linked to the iTraxx Europe, where leveraged is
dynamically adjusted based on the performance.
IXIS
Combined CDS
index
August
2005
Principal-protected note referencing a static credit
portfolio of DJ CDX.NA and iTraxx Europe).
Jet Stream / SG ICB
Dynamically
leveraged,
combined CDS
index
August
2005
Leverage is adjusted based on the performance (up to
20x).
Cedar / Royal Bank
of Canada
Managed long-short
combined CDX
index
Summer
2005
CPPI version of the long equity - short mezzanine
strategy.
Rabobank Credit
Strategie /
Rabobabnk
Dynamically
leveraged,
combined CDS
index
Summer
2005
100% principal-protected note (referencing
CDX/iTraxx IG and HY indices) with dynamic leverage
linked to default, spread, and interest rate risks.
ALPINe / Nomura
Source: Creditflux, Derivatives Week, Securitization News, and Risk Magazine.
The most recent trend seems to be the use of a managed portfolio where the leverage is dynamically
adjusted to boost returns. The dynamic leverage is aimed at quicker adjustment of risky exposure,
where the leverage increases following favorable performance and vice versa.

8
The first credit CPPI appeared in late 2003. The program, called the "Dynamic Participation Notes," issued by
ABN AMRO.
Nomura Fixed Income Research
(5)
V. Portfolio Performance
In this section, we analyze the performance of a CPPI portfolio. The "hedge" lowers the benefit of
leveraged returns for the CPPI in comparison to the underlying credit portfolio, but the downside risk
is also significantly reduced. In addition, the construct of CPPI contains some unique characteristics.
In particular, the risky exposure grows and contracts in response to favorable and poor performance,
respectively. Because the amount of risky exposure is readjusted based on the previous
performance, the overall portfolio performance is "path-dependent," in contrast to the case of a static
hedge portfolio.
9
In that sense, the performance of CPPI depends on the entire path of the risky
asset, not just its beginning and end values.
10

Below, we compare the performances of (1) a risky credit portfolio, (2) a CPPI, and (3) a static hedge
portfolio, under different performance scenarios. As mentioned before, a statically hedged portfolio
purchases a zero-coupon bond that matures to the amount of the "insured" principal and invests the
rest in the risky asset. In this section, we assume that the risky credit portfolio is managed based on
its mark-to-market portfolio value, where returns are driven by protection premium (i.e., spread)
received, default loss, and movements in the market spread.
A. When the Credit Portfolio Outperforms
Graph 1 shows the portfolio values of the CPPI portfolio and the risky credit portfolio. When the
credit market performs well (e.g., no defaults and tighter spreads), the portfolio of solely credit
exposure outperforms the CPPI portfolio, because the CPPI portfolio is only partially exposed to the
high-yielding assets.
Graph 1: Performance Comparison -
CPPI, Credit Portfolio, and Static Hedge
90
95
100
105
110
115
120
125
130
0 10 20 30 40 50 60 70 80 90 100
Days
P
o
r
t
f
o
l
i
o

V
a
l
u
e

(
$
)
CPPI
Credit portfolio
Static hedge

Source: Nomura Securities International

9
The static hedge portfolio invests in a zero-coupon bond that pays exactly the desired principal amount, while the
remainder of the amount of initial investment after purchasing the zero is invested in the risky asset. In such a
case, only the initial and terminal values of the risky asset determine the portfolio performance, regardless of the
exact path the risky asset value followed.
10
Another path dependent strategy is a dynamically managed portfolio of the underlying risky asset and a put
option. As listed options typically do not cover the entire period of investment, a new option needs to be
purchased (i.e., "rolled") every three months or so. Since the price of the option fluctuates with the performance of
the risky asset, the performance of the strategy is path dependent.
Nomura Fixed Income Research
(6)
B. When the Credit Portfolio Underperforms
Graph 2 shows the portfolio values of the CPPI portfolio and that of the pure credit portfolio during
times of high default losses and spread widening. As defaults pile up, the CPPI portfolio shifts its
allocation towards the risk-free bond away from the credit risk portfolio. This effectively pares down
the downside risk for the CPPI, increasing the chance of a full principal payment at maturity.
Graph 2: Performance Comparison
- CPPI, Credit Portfolio, and Static Hedge
80
85
90
95
100
105
110
115
120
0 10 20 30 40 50 60 70 80 90 100
Days
P
o
r
t
f
o
l
i
o

V
a
l
u
e

(
$
)
CPPI
Credit portfolio
Static hedge

Source: Nomura Securities International
C. High Volatility
In general, the CPPI structure is known to perform poorly when market volatility is high. Because the
CPPI structure requires buying the risky asset as its value increases and selling it as the value drops,
a quick market reversal (i.e., whipsaw movement) hurts the value of a CPPI. As a result, under high
volatility, the value of a CPPI could fall below that of the risky asset itself when the market turns south
and may not rise as much as the static hedge portfolio when the market recovers.
Graph 3 illustrates the performance of the CPPI and the credit portfolio. Around the center of the
graph, where the performance of the risky credit portfolio turns higher and then reverses, the value of
the CPPI falls below that of the credit portfolio on the downside. Also, towards the right of the graph
(around Day 90), the value of the credit portfolio rises sharply but that of the CPPI is no higher than
the static hedge portfolio.
Nomura Fixed Income Research
(7)
Graph 3: Performance Comparison
- CPPI, Credit Portfolio, and Static Hedge
90
95
100
105
110
115
120
125
130
0 10 20 30 40 50 60 70 80 90 100
Days
P
o
r
t
f
o
l
i
o

V
a
l
u
e

(
$
)
CPPI
Credit portfolio
Static hedge

Source: Nomura Securities International
In a similar vein, a sudden, large default after a period of relative calm would hurt the CPPI more than
a series of small defaults spread over time. Volatility, in this case, would be referring to the
"clustering" or "lumpiness" of defaults. That means, correlation and dispersion of the default risk can
significantly affect the performance of a CPPI.
A highly correlated credit portfolio tends to experience a large number of credits defaulting at once,
which may cause greater losses in the CPPI than a small number of defaults occurring at different
points in time. Many credits defaulting together after a period of relatively good performance would
cause a large amount of losses to the CPPI, as the risky exposure will have expanded. On the other
hand, scattered defaults would hurt less, because the credit exposure is kept relatively small each
period. Likewise, a portfolio with a high dispersion (i.e., a mix of high- and low-risk credits) would see
defaults that are less lumpy and more spread over time.
VI. Factors That Affect the Performance of a CPPI
In a CPPI, the most important risk is the possibility that the market conditions deteriorate so rapidly
(i.e., market "gapping") that asset allocation cannot be readjusted fast enough. In that case, the
portfolio value can drop below the bond floor, causing the principal protection to fail. If the principal
protection is explicit, however, the "gap" risk is shouldered by the sponsor of a CPPI. In relation to
the risk and return of a CPPI, there are mainly four factors to consider: (a) leverage, (b) spread
volatility, (c) clustering of defaults (correlation), and (d) changes in interest rates.
In the below, we compare the performance of the three strategies at varying levels of each factor,
while holding others unchanged. We assume an initial investment of $100 and a 10-year horizon.
The credit portfolio is assumed to pay a 10% coupon annually, but no coupon is paid out till maturity
on the CPPI. Hence, the average annual return is 10%, but fluctuations in the market spread also
affect the value of the credit portfolio. Also, we assume leverage of 4x, annual volatility of 10%,
11
and

11
We assumed that the stochastic variable follows the standard normal distribution.
Nomura Fixed Income Research
(8)
the risk-free rate of 1%, unless noted otherwise. For simplicity, we assume annual portfolio
adjustment and no defaults except for Section C.
A. Leverage
The risk and return of the CPPI is partly driven by the degree of leverage employed. For a given level
of bond floor, the higher the gearing factor is, the larger the amount invested in the risky asset is.
Below, we compare the performance of the CPPI portfolio at varying levels of the gearing factor. As
we can see, the average terminal value (thus return) of the CPPI portfolio increases with leverage, as
a higher proportion of the portfolio is invested in the risky asset (see the second row from the bottom).
Interestingly, at a gearing factor of six (m = 6), the CPPI underperforms the pure risky asset. While
the standard deviation is close, the average terminal value is lower for the CPPI than for the pure
credit portfolio.

Table 3: Impact of Leverage
(Simulated terminal value after 10 years vol = 10%)
m = 2 m = 4 m = 6
STRATEGY
Average STD Average STD Average STD
Pure credit portfolio 261 78 261 77 259 77
Static hedge 125 7 125 7 125 7
CPPI 155 31 218 66 236 75
% of risky exposure in CPPI 38% 76% 87%
% of failing protection in CPPI 0.0% 0.2% 0.2%
Source: Nomura Securities International
B. Spread Volatility
The performance of a CPPI is also driven by the volatility of the risky exposure. The table below
shows simulated terminal values for the three strategies at varying spread volatility levels for the
credit portfolio. As we can see, volatility does NOT affect the average terminal values for the risky
asset and the statically hedged portfolio. However, volatility affects the standard deviation of both
strategies, because volatility affects the distribution of terminal values for these portfolios.

Table 4: Impact of Volatility
(Simulated terminal value after 10 years gearing factor = 4)
Vol = 10% Vol = 20% Vol = 30%
STRATEGY
Average STD Average STD Average STD
Pure credit portfolio 261 77 257 159 257 260
Static hedge 125 7 124 15 124 25
CPPI 218 66 192 127 181 190
% of risky exposure in CPPI 76% 55% 42%
% of failing protection in CPPI 0.2% 26.3% 59.3%
Source: Nomura Securities International
In contrast, the average terminal value for the dynamically hedged CPPI portfolio actually falls as
volatility increases and asset allocation is shifted more frequently.
12
When volatility is high, the CPPI
portfolio reduces its risky exposure only after a market sell-off, failing to capture a market rally that
might follow. On the other hand, if the market declines after a rally, the CPPI would have a relatively
large exposure going into the sell-off. As a result, the CPPI portfolio would experience a significant
drop in value in a volatile environment. For a structure without an explicit principal guarantee, the
bottom row of the table shows that higher volatility dramatically increases the likelihood of protection
failure, where the terminal value falls below $100 (0.2% at 10% vol vs. 59% at 30% vol).

12
An analogous situation arises for an option-based dynamic hedge. Suppose an investor uses a series of
European put options where a contract is rolled into a new contract as it expires. In such a hedge, higher volatility
translates into a higher cost for an option, which would reduce the portfolio's overall return.
Nomura Fixed Income Research
(9)
C. Clustering of Defaults Correlation & Timing
Correlation of defaults and their timing also drive the performance of a CPPI. The table below shows
simulated terminal values for the three strategies at different default scenarios: (1) a small number of
defaults (i.e., 6% annually) every year, (2) "lumpy" defaults (i.e., 12%) occurring every other year, (3)
lumpy defaults (12%) in the first five years, and (4) lumpy defaults (12%) in the last five years. In this
section, all three strategies perform worse than in the previous sections, as we include default losses
in this section.
Table 5 shows that the average terminal value of the CPPI is slightly higher when defaults are spread
across periods (i.e., low correlation) than when defaults are concentrated in certain periods.
Moreover, the likelihood of protection failing, where the terminal value falls below $100, is only 1.9%
for Case (1), but it more than doubles to 4.3% for Case (2), indicating the clustering of defaults
increases the gap risk.
Interestingly, the timing of defaults also drives the performance of a CPPI. When defaults are "front-
loaded," or cluster in the early years, the CPPI suffers from the "close-out" effect, or the effect of
shrinking risky exposure missing out more favorable asset performance in the later years. This is
confirmed by the average size of credit portfolio, which is only 28% for the "front-loaded" case,
compared to 64% for the "back-loaded" case. Also, the likelihood of the terminal portfolio value falling
below $100 is slightly higher for the front-loaded case than for the back-loaded case.

Table 5: Impact of Default Correlation & Timing
(Simulated terminal value after 10 years gearing factor = 4)
Low correlation High correlation
High correlation:
front-loaded
High correlation:
back-loaded STRATEGY
Average STD Average STD Average STD Average STD
Pure credit portfolio 139 40 137 40 137 40 136 38
Static hedge 113 4 113 4 113 4 113 4
CPPI 124 27 120 24 118 24 122 24
% of risky exposure in CPPI 47% 48% 28% 64%
% of failing protection in CPPI 1.9% 4.3% 3.8% 2.9%
Source: Nomura Securities International
D. Interest Rates
The level of risk-free interest rate can also impact the CPPI performance. If the risk-free interest rate
is relatively low, the bond floor is relatively high, allowing only a small amount to be invested in the
risky asset. On the other hand, a larger risky exposure can be achieved under the high interest
environment. In Table 6, the average terminal value for the CPPI goes up from $184 to $245 as the
risk-free rate increases from 0.5% to 2%. The same is true for the static hedge, because the price of
the zero-coupon bond is lower and more can be invested in the risky asset.

Table 6: Impact of Varying Risk-free Rate
(Simulated terminal value after 10 years vol = 10%, m = 4)
0.5% 1% 2%
STRATEGY
Average STD Average STD Average STD
Pure credit portfolio 261 76 261 77 258 76
Static hedge 113 4 125 7 146 14
CPPI 184 54 218 66 245 75
% of risky exposure in CPPI 63% 76% 91%
Source: Nomura Securities International
If the risk-free interest rate rises during the term of the CPPI, what would happen? If interest rates
increase, the risk-free portion of the portfolio earns higher interest. More importantly, the bond floor
Nomura Fixed Income Research
(10)
falls with a higher risk-free rate, which allows a larger risky exposure in the subsequent periods.
13

The opposite phenomenon occurs when interest rates decline. If the interest rate falls rapidly, it can
result in a closeout of the CPPI, as the bond floor surges and the risky exposure is eliminated.
Hence, falling interest rates can increase the gap risk.
E. Other Factors to Consider
Additional factors that may affect the performance of a CPPI include: (1) the amount of protected
principal, and (2) frequency of dynamic hedge adjustments. The lower the protected amount, the
more the CPPI portfolio behaves like the pure risky asset. Volatility would be higher, but the average
terminal value would be also higher. If the CPPI portfolio is adjusted less frequently, it would
arguably increase the "gap risk," as the portfolio value can drop past the bond floor before the asset
allocation can be shifted.
If a portfolio manager is employed, the gap risk may be significantly mitigated, because a
deteriorating credit may be taken out before the portfolio value actually drops after credit spreads
widen or default losses occur. In fact, some newer CPPI deals employ a portfolio manager. As
mentioned above, the portfolio manager may dynamically adjust the level of leverage, instead of
keeping the gearing factor constant. The "adjustable" gearing factor would allow faster adjustment of
the risky exposure to keep up with a rapid market rally and sell-off.
The sponsor of a credit CPPI often bears the gap risk by explicitly guaranteeing the principal, but in
other cases the risk is born by the investor. Needless to say, an explicit principal guarantee
significantly reduces the risk of poor performance to the investor. When the deal sponsor explicitly
guarantees the principal payment, the risk exposure may be directly linked to the credit quality of the
sponsor.
14

VII. Conclusion
In this paper, we introduced the basics of the credit-linked CPPI investment. Like ordinary CPPI
using other risky assets, such as equity and hedge funds, the risk-return profile of a credit CPPI is
affected by (1) leverage, (2) asset volatility, and (3) the level of interest rates. However, credit-linked
CPPIs have certain distinctive features, mostly related to the nature of default losses. We have
shown that, all else equal, a credit CPPI tends to perform better if the reference portfolio is well
diversified (i.e., low correlation) and volatility is relatively low.
A credit CPPI comes with a great variety of features that affect its risk-return profile, and an investor
should carefully examine the specific structure of a credit CPPI. The investor should pay particularly
close attention to how the principal protection is provided and how the amount of risky exposure is
determined and managed. A credit CPPI is an interesting credit instrument, where the upside is
uncapped while the downside is mostly limited. Thus, a credit CPPI offers a diversification alternative
to a traditional CDO, where the upside is limited at the level of pre-determined spread while the
downside could be significant.

13
Another way to look at this point may be a portfolio of mostly risk-free asset with a long call option on the risky
asset. By the put-call parity, the combined position is the equivalent of a portfolio of mostly risky asset with a long
put option on the risky asset, or a statically hedged portfolio. As the risk-free interest rate rises, the risk-free asset
falls in value but the value of the call option rises.
14
For example, Moody's recently assigned credit ratings to tranches of a European CPPI deal, called Dynamo I,
based on the deal's exposure to the credit quality of BNP Paribas. Moody's Assigns Definitive Ratings to the
Series Dynamo 1 issued by Aquarius + Investments Plc., Moody's rating action (22 July 2005).
Nomura Fixed Income Research
(11)
VIII. Technical Appendix
The CPPI is based on the linear allocation rule. The portfolio's net asset value ("NAV") is the sum of
the risk-free bond plus the risky asset, less net borrowing. At any point t, the bond floor is defined as
the present value of zero-coupon bond that matures at T to the insured amount:
F
t
= F
T
e
-r(T-t)

The difference between the current portfolio NAV and the bond floor is called cushion, or C. This
amount multiplied by the gearing factor, m,
E
t
= mC
t

is invested in the risky exposure. However, the borrowing constraints often limit the maximum
leverage. For example, the overall leverage may be limited to the portfolio NAV, where no borrowing
is allowed. With such constraints, the amount of risky exposure is determined by
E
t
= min [mC
t
, hV
t
]
where h is the maximum overall leverage allowed, and V is the portfolio NAV. Initially, amount e
0
is
invested in the risky asset, and the difference between the initial investment, V
0
, and E
0
is invested in
the risk-free asset. In each period, E
t
is recalculated as the bond floor and the portfolio NAV change,
and the asset allocation is readjusted. Because the portfolio is dynamically managed and its value is
path dependent, there is no simple formula for the terminal value of a CPPI. Only if there are no
leverage restrictions, and the value of a CPPI portfolio at time t can be written as
m
t t
rt
t
CPPI
t
S e F S m V + =
0
) , (
where S is the value of the risky asset and
(
(

|
|
.
|

\
|
|
.
|

\
|

|
|
.
|

\
|
= t m r m r
S
C
m t
2 2
1
exp
2
2 2
0
0

.
if we assume that the risky asset follows the standard geometric Brownian motion, or the process
] [
t t t
dW dt S dS + = .
This relation can be derived as follows. The portfolio value at t is given by
t
t
t
t
t
t t t
S
dS
E
B
dB
E V dV + = ) (
where the risk-free asset follows the process B
t
. The value of the cushion C
t
is
t
t
t
t
t
t t
t
t
t
t
t
t
t t
t t t
S
dS
mC
B
dB
mC C
dF
S
dS
E
B
dB
E V
F V d dC
+ =
+ =
=
) (
) (
) (

This is further simplified by using the expression for the process S
t
and assuming the risk-free rate of r
Nomura Fixed Income Research
(12)
( )
[ ]
t t
t
t
t
t t
dW m dt r r m C
dW dt m
B
dB
m C dC


+ + =
(

+ + =
) ) ( (
) 1 (

Hence,
(

+ + = t m r r m W m C C
t t
)
2
) ( ( exp
2
2
0

.
Also, from the relation
(

|
.
|

\
|
+ = t W S S
t t
2
0
2
1
exp
we get
(
(

|
.
|

\
|

|
|
.
|

\
|
= t
S
S
W
t
t
2
0
2
1
ln
1

.
Plugging this into the expression for C
t
, we arrive at

m
t
m
t
S t m r m r
S
C
C
(
(

|
|
.
|

\
|

|
|
.
|

\
|

|
|
.
|

\
|
=
2 2
exp
2
2
2
0
0

.
Finally, we can obtain the portfolio value V
t
CPPI
(m, S
t
) as a sum of C
t
and F
t
.

IX. Reference
[1] Bookstaber, R., and J. Langsam, 1988, Portfolio Insurance Trading Rules, The Journal of Futures
Markets 8, 15-31.
[2] Perold, A., and W. Sharpe, 1988, Dynamic Strategies for Asset Allocation, Financial Analysts
Journal 44, 16-27.
[3] Bertrand, P., and J. Prigent, 2002, Portfolio Insurance Strategies: OBPI versus CPPI, working
paper, University of Cergy-Pontoise THEMA.
[4] Lundvik, A., 2005, Portfolio Insurance Methods for Index Funds, working paper, Uppsala
University.


E N D
Nomura Fixed Income Research
(13)
Recent Nomura Fixed Income Research
Fixed Income General Topics
U.S. Fixed Income 2005 Mid-Year Outlook/Review (30 Jun 2005)
Structured Finance Trends Yield Spreads, Credit Support, and
Collateral Performance The Big Picture (27 Jun 2005)
Bond Portfolio Credit Analysis The CDO Approach (24 May 2005)
Update on U.S. Fixed Income Market Conditions (28 Feb 2005)
Report from Arizona 2005: Coverage of Selected Sessions of ABS West 2005 (14 Feb
2005)
U.S. Fixed Income 2005 Outlook/2004 Review (16 Dec 2004)
ABS/CDO
CDO/CDS Update (6 Sep 2005)
Constant Maturity CDS (CMCDS) A Guide (20 May 2005)
CDO/Credit Derivatives 2005 Conference Notes (11 Apr 2005)
CDO Equity, Correlation, and IRR (21 Mar 2005)
CDOs-Squared Demystified (4 Feb 2005)
Student Loan ABS 101 (26 Jan 2005)
MBS
GNPL Prepayments April Factor (13 Apr 2005)
FHA/VA Monthly (12 Apr 2005)
Some Investment Characteristics of GNMA Project Loan Securities (4 Apr 2005)
Strategy
Corporate Credit Quality: Limited Upside Potential (30 Aug 2005)
CMBS: New Orleans MSA-Hurricane Katrina Exposure (30 Aug 2005)
CMBS Spreads: Mean Reversion & Breakeven Levels (30 Aug 2005)
Hurricane Katrina: Flattens Curve, Pushes Oil > $70 (29 Aug 2005)
MBS: Performance During Last Yield Curve Inversion (25 Aug 2005)
Swap Spreads: Seasonality & Corporate Supply (22 Aug 2005)
Trade Recommendation: Callable Agencies (19 Aug 2005)
Portfolio Strategy: Time to increase Cash! (19 Aug 2005)
CDS & Corporate Bonds: Event Risk @ Time Warner (17 Aug 2005)
Treasury Bonds: Shorter Bonds looking more attractive (16 Aug 2005)
CMBS: Levered Accounts & Subordinated Bond Spreads (16 Aug 2005)
CDS: Ford Motor Credit Co. vs. GMAC (10 Aug 2005)
MBS: Market Check-up August Update (9 Aug 2005)
CMBS: Balance Guarantee Swaps Good Value? (9 Aug 2005)
Agency Bullets: 5 Yrs look cheap vs. 10-Years (8 Aug 2005)
MBS Credit: Updated PMI Housing Risk Market Rankings (4 Aug 2005)
CMBS: Conduit Deal Trends & Stressed LTV (3 Aug 2005)
Swap Spread Strategy: August Trade Ideas (3 Aug 2005)
Corporate Bonds: LBO Risk on the Rise (3 Aug 2005)
MBS: Strong Housing Market Limits Extension Risk (29 Jul 2005)
Trade Recommendation: Overweight TIPS (22 Jul 2005)
CMBS: 3 Largest U.S. Grocers Credit Rating cut to BBB- (18 Jul 2005)
Corporate Bonds: Event Risk & Potential LBO Candidates (18 Jul 2005)
MBS Credit: Housing Bubbles & Loan Quality (15 Jul 2005)
RMBS: Second Mortgages and Piggyback Loans (15 Jul 2005)
Swap Spread Strategy: July Trade Ideas (7 Jul 2005)
Yield Curve Views & Treasury Strategy (7 Jul 2005)
Supreme Courts Eminent Domain Ruling: Pro-Development (6 Jul 2005)
Fed Funds, Treasury and Swap Curves: Expectations and Ideas (13 Jun 2005)
MBS Market Check-up: June Update (8 Jun 2005)
CMBS: Impact of Proposed Military Base Closings (6 Jun 2005)
California Housing and IO Loans (6 Jun 2005)

Nomura Fixed Income Research
(14)


I Michiko Whetten, a research analyst employed by Nomura Securities International, Inc., hereby certify that all of the
views expressed in this research report accurately reflect my personal views about any and all of the subject securities or
issuers discussed herein. In addition, I hereby certify that no part of my compensation was, is, or will be, directly or
indirectly related to the specific recommendations or views that I have expressed in this research report, nor is it tied to
any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc
or by any other Nomura Group company or affiliate thereof.
Copyright 2005 Nomura Securities International, Inc.
This publication contains material that has been prepared by the Nomura entity identified on the banner at the top of page 1 herein
and, if applicable, with the contributions of one or more Nomura entities whose employees and their respective affiliations are
specified on page 1 herein. This publication contains material prepared by one or more of the following affiliates or subsidiaries of
Nomura Holdings, Inc. (collectively, the Nomura Group): Nomura Securities Co., Ltd. ("NSC") and Nomura Research Institute, Ltd.,
Tokyo, Japan; Nomura International plc and Nomura Research Institute Europe, Limited, United Kingdom; Nomura Securities
International, Inc. ("NSI") and Nomura Research Institute America, Inc., New York, NY; Nomura International (Hong Kong) Ltd.,
Hong Kong; Nomura Singapore Ltd., Singapore; Nomura Australia Ltd., Australia; P.T. Nomura Indonesia, Indonesia; Nomura
Advisory Services (Malaysia) Sdn. Bhd., Malaysia; Nomura International (Hong Kong) Ltd., Taipei Branch, Taiwan; or Nomura
International (Hong Kong) Ltd., or Nomura International (Hong Kong) Ltd., Seoul Branch, Korea. This material is: (i) for your private
information, and we are not soliciting any action based upon it; (ii) not to be construed asa bid or an offer to buy or sell any security
in any jurisdiction where such bid or offer would be illegal; and (iii) is based upon information that we consider reliable, but we do
not represent that it is accurate or complete, and it should not be relied upon as such. Opinions expressed are current as of the
date appearing on this material only and the information, including the opinions contained herein are subject to change without
notice. The Nomura Group. may perform investment banking or other services (including acting as advisor, manager or lender) for,
or solicit investment banking or other business from, companies mentioned herein. The Nomura Group, its officers, directors and
employees, including persons involved in the preparation or issuance of this material may have long or short positions in, and buy or
sell (or make a market in), the securities, or derivatives (including options) thereof, of companies mentioned herein, or related
securities or derivatives. Fixed income research analysts receive compensation based on various factors, including quality and
accuracy of research, firms overall performance and revenue (including the firms fixed income department), client feedback and
the analysts seniority, reputation and experience. Non-US members of the Nomura Group, their officers, directors and employees
may, to the extent it relates to non-US issuers and is permitted by applicable law, have acted upon or used this material, prior to or
immediately following its publication. Foreign currency-denominated securities are subject to fluctuations in exchange rates that
could have an adverse effect on the value or price of, or income derived from the investment. In addition, investors in securities
such as ADRs, the values of which are influenced by foreign currencies, effectively assume currency risk. The securities described
herein may not have been registered under the U.S. Securities Act of 1933, and, in such case, may not be offered or sold in the
United States or to U.S. persons except in compliance with an exemption from the registration requirements of such Act. Unless
governing law permits otherwise, you must contact a Nomura entity in your home jurisdiction if you want to use our services in
effecting a transaction in the securities mentioned in this material. This publication has been approved for distribution in the United
Kingdom and European Union by Nomura International plc, which is authorised and regulated by the UK Financial Services
Authority (FSA) and is a member of the London Stock Exchange. It is intended only for investors who are market counterparties
or intermediate customers as defined by FSA, and may not, therefore, be redistributed to other classes of investors. This
publication has also been approved for distribution in Hong Kong by Nomura International (Hong Kong) Ltd. (NIHK), which is
regulated by the Hong Kong Securities and Futures Commission (SFC) under Hong Kong laws and in Singapore by Nomura
Singapore Limited. Neither NIplc nor NIHK hold an Australian financial services license as both are exempt from the requirement to
hold this license in respect of the financial services either provides. NSI accepts responsibility for the contents of this material when
distributed in the United States.
Nomura International plc and other Nomura Group entities manage conflicts identified through the following: their Chinese Wall,
confidentiality and independence policies, maintenance of a Stop List and a Watch List, personal account dealing rules, policies and
procedures for managing conflicts of interest arising from the allocation and pricing of securities and impartial investment research
and disclosure to clients via client documentation. Disclosure information is available at
http://www.nomura.com/research/disclosures/public/search.asp. No part of this material may be copied or distributed without the
prior written consent of the Nomura Group member identified in the banner on page 1 of this report. Further information on any of
the securities mentioned herein may be obtained upon request. If this publication has been distributed by electronic transmission,
such as e-mail, then such transmission cannot be guaranteed to be secure or error-free as information could be intercepted,
corrupted, lost, destroyed, arrive late or incomplete, or contain viruses. The sender therefore does not accept liability for any errors
or omissions in the contents of this publication, which may arise as a result of electronic transmission. If verification is required,
please request a hard-copy version.


NEW YORK TOKYO LONDON
Nomura Securities International Nomura Securities Company Nomura International PLC
2 World Financial Center, Building B 2-2-2, Otemachi, Chiyoda-Ku Nomura House
New York, NY 10281 Tokyo, Japan 100-8130 1 St Martin's-le-grand
(212) 667-9300 81 3 3211 1811 London EC1A 4NP
44 207 521 2000
David P. Jacob 212.667.2255 International Head of Research
Nomura U.S. Fixed Income Research
David Resler 212.667.2415 Head of U.S. Economic Research
Mark Adelson 212.667.2337 Securitization/ABS Research
John Dunlevy 212.667.9298 Cross Market Strategist
Arthur Q. Frank 212.667.1477 MBS Research
Weimin Jin 212.667.9679 Quantitative Research
Michiko Whetten 212.667.2338 Quantitative Credit Analyst
James Manzi 212.667.2231 CMBS Research/Strategy
Gerald Zukowski Deputy Chief Economist
Xiang Long Quantitative Analyst
Cristian Pasarica Quantitative Analyst
Elizabeth Bartlett 212.667.2339 Analyst
Diana Berezina 212.667.9054 Analyst
Benjamin Cheng Analyst
Jeremy Garfield 212.667.2158 Analyst
Edward Santevecchi 212.667.1314 Analyst
Pui See Wong 212.667.2132 Analyst
Tomoko Nago-Kern Translator
Kyoko Teratani Translator