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Dynamic Derivative Strategies

Jun Liu and Jun Pan

No 4334-02, Working papers from Massachusetts Institute of Technology (MIT), Sloan School of Management

Abstract: 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.

Date: 2003-09-25
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