In: Finance
What is replicating portfolio? Is it always using bonds and shares ? How to determine the strategy?
Replicating portfolio for a given asset or series of cash flows is a portfolio of assets with the same properties (especially cash flows). This is meant in two distinct senses: static replication, where the portfolio has the same cash flows as the reference asset (and no changes need to be made to maintain this), and dynamic replication, where the portfolio does not have the same cash flows, but has the same "Greeks" as the reference asset, meaning that for small changes to underlying market parameters, the price of the asset and the price of the portfolio change in the same way.
No it's not always using bonds and shares, it can be applied to derivatives pricing and insurance contracts too.
Given an asset or liability, an offsetting replicating portfolio is called a static hedge or dynamic hedge, and constructing such a portfolio (by selling or purchasing) is called static hedging or dynamic hedging. The notion of a replicating portfolio is fundamental to rational pricing, which assumes that market prices are arbitrage-free – concretely, arbitrage opportunities are exploited by constructing a replicating portfolio.
Hence the strategy is to construct a portfolio in such a way that it creates an arbitrage opportunity by offsetting the cash flows through purchasing or selling and vice-versa