Derivatives-based portfolio decisions: an expected utility insight

Marcos Escobar-Anel (), Matt Davison () and Yichen Zhu ()
Additional contact information
Marcos Escobar-Anel: Western University
Matt Davison: Western University
Yichen Zhu: Western University
Authors registered in the RePEc Author Service: Marcos Escobar Anel ()

Annals of Finance, 2022, vol. 18, issue 2, No 3, 217-246

Abstract: Abstract This paper challenges the use of stocks in portfolio construction, instead we demonstrate that Asian derivatives, straddles, or baskets could be more convenient substitutes. Our results are obtained under the assumptions of the Black–Scholes–Merton setting, uncovering a hidden benefit of derivatives that complements their well-known gains for hedging, risk management, and to increase utility in market incompleteness. The new insights are also transferable to more advanced stochastic settings. The analysis relies on the infinite number of optimal choices of derivatives for a maximized expected utility theory agent; we propose risk exposure minimization as an additional optimization criterion inspired by regulations. Working with two assets, for simplicity, we demonstrate that only two derivatives are needed to maximize utility while minimizing risky exposure. In a comparison among one-asset options, e.g. American, European, Asian, Calls and Puts, we demonstrate that the deepest out-of-the-money Asian products available are the best choices to minimize exposure. We also explore optimal selections among straddles, which are better practical choice than out-of-the-money Calls and Puts due to liquidity and rebalancing needs. The optimality of multi-asset derivatives is also considered, establishing that a basket option could be a better choice than one-asset Asian call/put in many realistic situations.

Keywords: Expected utility theory; Constant relative risk aversion (CRRA) utility; Optimal derivative choice; Black–Scholes pricing (search for similar items in EconPapers)
JEL-codes: C44 C61 C63 G11 G13 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://link.springer.com/10.1007/s10436-022-00409-8 Abstract (text/html)
Access to full text is restricted to subscribers.

Related works:
Working Paper: Derivatives-based portfolio decisions. An expected utility insight (2022)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:kap:annfin:v:18:y:2022:i:2:d:10.1007_s10436-022-00409-8

Ordering information: This journal article can be ordered from
http://www.springer.com/finance/journal/10436/PS2

DOI: 10.1007/s10436-022-00409-8

Access Statistics for this article

Annals of Finance is currently edited by Anne Villamil

More articles in Annals of Finance from Springer
Bibliographic data for series maintained by Sonal Shukla () and Springer Nature Abstracting and Indexing ().