On the Method of Optimal Portfolio Choice by Cost-Efficiency

Ludger Rüschendorf and Viktor Wolf

Applied Mathematical Finance, 2016, vol. 23, issue 2, 158-173

Abstract: We develop the method of optimal portfolio choice based on the concept of cost-efficiency in two directions. First, instead of specifying a payoff distribution in an unique way, we allow customer-defined constraints and preferences for the choice of a distributional form of the payoff distribution. This leads to a class of possible payoff distributions. We determine upper and lower bounds for the corresponding strategies in stochastic order and describe related upper and lower price bounds for the induced class of cost-efficient payoffs. While the results for the cost-efficient payoff given so far in the literature in the context of Lévy models are based on the Esscher pricing measure we use as alternative the method of empirical pricing measures. This method is well established in the literature and leads to more precise pricing of options and their cost-efficient counterparts. We show in some examples for real market data that this choice is numerically feasible and leads to more precise prices for the cost-efficient payoffs and for values of the efficiency loss.

Date: 2016
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DOI: 10.1080/1350486X.2016.1204238

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