IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

Dynamic derivative strategies

  • Liu, Jun
  • Pan, Jun

This paper studies the optimal investment strategy of an investor who can access not only the bond and the stock markets, but also the derivatives market. We consider the investment situation where, in addition to the usual diffusive price shocks, the stock market experiences sudden price jumps and stochastic volatility. The dynamic portfolio problem involving derivatives is solved in closed-form. Our results show that derivatives are important in providing access to the risk and return tradeoffs associated with the volatility and jump risks. Moreover, as a vehicle to the volatility risk, derivatives are used by non-myopic investors to exploit the time-varying opportunity set; and as a vehicle to the jump risk, derivatives are used by investors to disentangle their simultaneous exposure to the diffusive and jump risks in the stock market. In addition, derivatives investing also affects investors' stock position because of the interaction between the two markets. Finally, calibrating our model to the S&P 500 index and options markets, we find sizable portfolio improvement for taking advantage of derivatives.

(This abstract was borrowed from another version of this item.)

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.sciencedirect.com/science/article/B6VBX-48M7Y9Y-2/2/b684a3cf74931176ec39f9c57b4994b4
Download Restriction: Full text for ScienceDirect subscribers only

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 69 (2003)
Issue (Month): 3 (September)
Pages: 401-430

as
in new window

Handle: RePEc:eee:jfinec:v:69:y:2003:i:3:p:401-430
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. Chernov, Mikhail & Ghysels, Eric, 2000. "A study towards a unified approach to the joint estimation of objective and risk neutral measures for the purpose of options valuation," Journal of Financial Economics, Elsevier, vol. 56(3), pages 407-458, June.
  3. Darrell Duffie & Jun Pan & Kenneth Singleton, 1999. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," NBER Working Papers 7105, National Bureau of Economic Research, Inc.
  4. Ross, Stephen A, 1976. "Options and Efficiency," The Quarterly Journal of Economics, MIT Press, vol. 90(1), pages 75-89, February.
  5. Gurdip Bakshi & Nikunj Kapadia, 2003. "Delta-Hedged Gains and the Negative Market Volatility Risk Premium," Review of Financial Studies, Society for Financial Studies, vol. 16(2), pages 527-566.
  6. Bakshi, Gurdip & Madan, Dilip, 2000. "Spanning and derivative-security valuation," Journal of Financial Economics, Elsevier, vol. 55(2), pages 205-238, February.
  7. Philippe Jorion, 1988. "On Jump Processes in the Foreign Exchange and Stock Markets," Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 427-445.
  8. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
  9. Bates, David S., 2000. "Post-'87 crash fears in the S&P 500 futures option market," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 181-238.
  10. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
  11. Dilip B. Madan & Xing Jin & Peter Carr, 2001. "Optimal investment in derivative securities," Finance and Stochastics, Springer, vol. 5(1), pages 33-59.
  12. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October.
  13. Merton, Robert C & Scholes, Myron S & Gladstein, Mathew L, 1978. "The Returns and Risk of Alternative Call Option Portfolio Investment Strategies," The Journal of Business, University of Chicago Press, vol. 51(2), pages 183-242, April.
  14. 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.
  15. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  16. Charles Quanwei Cao & Gurdip S. Bakshi & Zhiwu Chen, 1997. "Empirical Performance of Alternative Option Pricing Models," Yale School of Management Working Papers ysm65, Yale School of Management.
  17. G. William Schwert, 1988. "Why Does Stock Market Volatility Change Over Time?," NBER Working Papers 2798, National Bureau of Economic Research, Inc.
  18. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  19. Arditti, Fred D. & John, Kose, 1980. "Spanning the State Space with Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(01), pages 1-9, March.
  20. Brennan, Michael J & Cao, H Henry, 1996. "Information, Trade, and Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 163-208.
  21. Green, Richard C. & Jarrow, Robert A., 1987. "Spanning and completeness in markets with contingent claims," Journal of Economic Theory, Elsevier, vol. 41(1), pages 202-210, February.
  22. Merton, Robert C & Scholes, Myron S & Gladstein, Mathew L, 1982. "The Returns and Risks of Alternative Put-Option Portfolio Investment Strategies," The Journal of Business, University of Chicago Press, vol. 55(1), pages 1-55, January.
  23. Naik, Vasanttilak & Lee, Moon, 1990. "General Equilibrium Pricing of Options on the Market Portfolio with Discontinuous Returns," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 493-521.
  24. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
  25. Peter Carr & Jin Xing & Madam Dilip, 2001. "Optimal Investment in Derivative Securities," Working Papers wpn01-01, Warwick Business School, Finance Group.
  26. Dong-Hyun Ahn & Jacob Boudoukh & Matthew Richardson & Robert F. Whitelaw, 1999. "Optimal Risk Management Using Options," Journal of Finance, American Finance Association, vol. 54(1), pages 359-375, 02.
  27. M. B. Haugh & A. W. Lo, 2001. "Asset allocation and derivatives," Quantitative Finance, Taylor & Francis Journals, vol. 1(1), pages 45-72.
  28. Joshua D. Coval, 2001. "Expected Option Returns," Journal of Finance, American Finance Association, vol. 56(3), pages 983-1009, 06.
  29. Officer, R R, 1973. "The Variability of the Market Factor of the New York Stock Exchange," The Journal of Business, University of Chicago Press, vol. 46(3), pages 434-53, July.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:eee:jfinec:v:69:y:2003:i:3:p:401-430. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.