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An Explicit Option-Based Strategy That Outperforms Dollar Cost Averaging

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  • STEVEN VANDUFFEL

    ()
    (Faculty of Economics, Vrije Universiteit Brussel, Pleinlaan 2, 1050 Brussels, Belgium)

  • ALES AHCAN

    (Faculty of Economics, University of Ljubljana, Kardeljeva ploscad 17, Ljubljana, Slovenia)

  • LUC HENRARD

    (Hong Kong University of Science and Technology, Hong Kong; Catholic University of Louvain, Place de l'Université 1, 1348 Louvain-la-Neuve, Belgium)

  • MATEUSZ MAJ

    (Faculty of Economics, Vrije Universiteit Brussel, Pleinlaan 2, 1050 Brussels, Belgium)

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    Abstract

    Dollar cost averaging (DCA) is a widely employed investment strategy in financial markets. At the same time it is also well documented that such gradual policy is sub-optimal from the point of view of risk averse decision makers with a fixed investment horizon T > 0. However, an explicit strategy that would be preferred by all risk averse decision makers did not yet appear in the literature. In this paper, we give a novel proof for the suboptimality of DCA when (log) returns are governed by Lévy processes and we construct a dominating strategy explicitly. The optimal strategy we propose is static and consists in purchasing a suitable portfolio of path-independent options. Next, we discuss a market governed by a Brownian motion in more detail. We show that the dominating strategy amounts to setting up a portfolio of power options. We provide evidence that the relative performance of DCA becomes worse in volatile markets, but also give some motivation to support its use. We also analyse DCA in presence of a minimal guarantee, explore the continuous setting and discuss the (non) uniqueness of the dominating strategy.

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    Bibliographic Info

    Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

    Volume (Year): 15 (2012)
    Issue (Month): 02 ()
    Pages: 1250013-1-1250013-19

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    Handle: RePEc:wsi:ijtafx:v:15:y:2012:i:02:p:1250013-1-1250013-19

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    Related research

    Keywords: Lévy process; minimal guarantee; Jensen's inequality; Brownian bridge; hedging; Esscher transform;

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    Cited by:
    1. Dirk Ulbricht, 2013. "Stock Investments for Old-Age: Less Return, More Risk, and Unexpected Timing," Discussion Papers of DIW Berlin 1324, DIW Berlin, German Institute for Economic Research.
    2. Ewald, Christian-Oliver & Menkens, Olaf & Hung Marten Ting, Sai, 2013. "Asian and Australian options: A common perspective," Journal of Economic Dynamics and Control, Elsevier, vol. 37(5), pages 1001-1018.
    3. Dirk Ulbricht, 2014. "John Doe's Old-Age Provision: Dollar Cost Averaging and Time Diversification," Discussion Papers of DIW Berlin 1376, DIW Berlin, German Institute for Economic Research.

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