Asset allocation and derivatives

M. B. Haugh and Andrew Lo ()

Quantitative Finance, 2001, vol. 1, issue 1, 45-72

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.

Date: 2001
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DOI: 10.1080/713665551

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