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Asset allocation and derivatives

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  • M. B. Haugh
  • A. W. Lo

Abstract

The fact that derivative securities are equivalent to specific dynamic trading strategies in complete markets suggests the possibility of constructing buy-and-hold portfolios of options that mimic certain dynamic investment policies, e.g. asset-allocation rules. We explore this possibility by solving the following problem: given an optimal dynamic investment policy, find a set of options at the start of the investment horizon which will come closest to the optimal dynamic investment policy. We solve this problem for several combinations of preferences, return dynamics and optimality criteria, and show that under certain conditions, a portfolio consisting of just a few options is an excellent substitute for considerably more complex dynamic investment policies.

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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 1 (2001)
Issue (Month): 1 ()
Pages: 45-72

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Handle: RePEc:taf:quantf:v:1:y:2001:i:1:p:45-72

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Cited by:
  1. Das, Sanjiv R. & Statman, Meir, 2013. "Options and structured products in behavioral portfolios," Journal of Economic Dynamics and Control, Elsevier, vol. 37(1), pages 137-153.
  2. Robert Kohn & Oana Papazoglu-Statescu, 2006. "On the equivalence of the static and dynamic asset allocation problems," Quantitative Finance, Taylor & Francis Journals, vol. 6(2), pages 173-183.
  3. Liu, Jun & Longstaff, Francis & Pan, Jun, 2001. "Dynamic Asset Allocation with Event Risk," University of California at Los Angeles, Anderson Graduate School of Management qt9fm6t5nb, Anderson Graduate School of Management, UCLA.
  4. Liu, Jun & Pan, Jun, 2003. "Dynamic derivative strategies," Journal of Financial Economics, Elsevier, vol. 69(3), pages 401-430, September.
  5. Liu, Jun & Pan, Jun, 2003. "Dynamic Derivative Strategies," Working papers 4334-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  6. Amir E. Khandani & Andrew W. Lo & Robert C. Merton, 2009. "Systemic Risk and the Refinancing Ratchet Effect," Harvard Business School Working Papers 10-023, Harvard Business School, revised Jul 2010.
  7. Robert C. Merton & Zvi Bodie, 2004. "The Design of Financial Systems: Towards a Synthesis of Function and Structure," NBER Working Papers 10620, National Bureau of Economic Research, Inc.
  8. Jun Pan & Allen Poteshman, 2004. "The Information of Option Volume for Future Stock Prices," NBER Working Papers 10925, National Bureau of Economic Research, Inc.
  9. Branger, Nicole & Hansis, Alexandra, 2012. "Asset allocation: How much does model choice matter?," Journal of Banking & Finance, Elsevier, vol. 36(7), pages 1865-1882.
  10. Chiara Oldani, 2005. "An Overview of the Literature about Derivatives," Macroeconomics 0504004, EconWPA.
  11. Roger Bowden & Jennifer Zhu, 2010. "Multi-scale variation, path risk and long-term portfolio management," Quantitative Finance, Taylor & Francis Journals, vol. 10(7), pages 783-796.
  12. Judd, Kenneth L. & Leisen, Dietmar P.J., 2010. "Equilibrium open interest," Journal of Economic Dynamics and Control, Elsevier, vol. 34(12), pages 2578-2600, December.
  13. Topaloglou, Nikolas & Vladimirou, Hercules & Zenios, Stavros A., 2011. "Optimizing international portfolios with options and forwards," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3188-3201.

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