A huge rise in the number of capital protected products using constant portfolio proportion insurance being placed in the last month has triggered demand for gap notes to lay off some of the risk. In a CPPI structure the derivatives house provides protection by moving capital out of the underlying and into risk free assets. Gap risk refers to the risk that the market will plummet so quickly that the structuring firm isn't able to move the capital in time.
Gap notes have been around in the inter-bank market for about one year, but are not liquid products and this has prevented them from being a viable hedge. "There is certainly enough demand for these products now," noted one trader of CPPI structures. "It would be a breakthrough if gap notes became really liquid," he added.
The gap note is essentially a one- to five-year note which pays a yield above LIBOR, providing equity indices do not fall more than a certain amount in one day, usually around 15-20%. This allows issuers of CPPI products to offset losses on the CPPI structures with profits from the gap note.
