Question

In: Finance

What is replicating portfolio? Is it always using bonds and shares ? How to determine the...

What is replicating portfolio? Is it always using bonds and shares ? How to determine the strategy?

Solutions

Expert Solution

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


Related Solutions

The current value of INDY index is 1,015 and a portfolio replicating this index has a...
The current value of INDY index is 1,015 and a portfolio replicating this index has a value of $1,015. European options with a strike price K = $1,000 and maturing in T = 6 months trade on YBM. The continuously compounded, risk-free interest rate r is 5 percent per year. The stocks underlying INDY index have a dividend yield δ = 1.2 percent per year. A trader quotes a call price c = $80 and a put price p =...
Rank the asset classes appropriately for a diversified portfolio; Bonds Cash Property Shares Commodities
Rank the asset classes appropriately for a diversified portfolio; Bonds Cash Property Shares Commodities
Problem A. Construct a Replicating Portfolio (RP) to replicate a 1.5-year Bond-0 that pays A1 percent...
Problem A. Construct a Replicating Portfolio (RP) to replicate a 1.5-year Bond-0 that pays A1 percent of coupon per year. The available bonds for replication are: a one year zero coupon Bond-1, a 1.5-year Bond-2 that pays A2 percent coupon per year, and a 1-year Bond-3 which pays A3 percent coupon per year. All the bonds (Bond-0, Bond-1, Bond-2, and Bond-3) have the same face value of $100 and pay their annual coupons two times a year. Compute an arbitrage...
Irena Davies manages a portfolio of 200 ordinary shares. Her staff classified the portfolio of shares...
Irena Davies manages a portfolio of 200 ordinary shares. Her staff classified the portfolio of shares by ‘industry sector’ and ‘investment objective’. Investment Objective Industry Sector Electronics Airlines Healthcare Total Growth 100 10 40 150 Income 20 20 10 50 Total 120 30 50 200 Are 'Healthcare' and 'Income' independent, why or why not? Select one: No, because P(Healthcare | Income) ≠ P(Healthcare) No, because P(Healthcare) ≠ P(Income) Yes, because P(Healthcare ∩ Income) = P(Healthcare) P(Income) Yes, because P(Healthcare ∩...
describe with an example how a swap can be viewed as a portfolio of two bonds.
describe with an example how a swap can be viewed as a portfolio of two bonds.
What will happen over time to a cell that is actively replicating but does not express...
What will happen over time to a cell that is actively replicating but does not express telomerase? Explain your reasoning.
Is raising capital by issuing bonds always the best option? What are some of the disadvantages...
Is raising capital by issuing bonds always the best option? What are some of the disadvantages of issuing bonds ?
Which of the following is always true: Diluted weighted shares is always less than or equal...
Which of the following is always true: Diluted weighted shares is always less than or equal to basic weighted average shares Diluted weighted shares is always greater than or equal to basic weighted average shares Shares outstanding on the period end date is the value used to calculate Basic EPS Shares outstanding on the period end date is the value used to calculate Diluted EPS
A reason to hold a portfolio of S&P 500 shares is a. Such a portfolio achieves...
A reason to hold a portfolio of S&P 500 shares is a. Such a portfolio achieves close to optimal gains from equity diversification b. Such a portfolio has returns that approach market returns c. Such a portfolio can be easily acquired through mutual funds d. All of the above
What is the Macaulay’s Duration of a portfolio of bonds that invests 40% in a 5-year...
What is the Macaulay’s Duration of a portfolio of bonds that invests 40% in a 5-year zero coupon bond with a par of $100 and 60% in a 3 year, 5% coupon interest bond (p.a.), with a par of $100. Assume Yield to Maturity is 8% p.a.? *Please assist with a worked answer
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT