Explicit Representation of Cost-Efficient Strategies

Abstract:     
This paper uses the preference free framework proposed by Dybvig (1988) and Cox and Leland (1982, 2000) to analyze dynamic portfolio strategies. In general there will be a set of dynamic strategies that have the same payoff distribution. We are able to characterize a lowest cost strategy (a “cost-efficient” strategy) and to give an explicit representation of it. As an application, for any given path-dependent strategy, we show how to construct a financial derivative that dominates in the sense of first-order stochastic dominance. We provide new cost-efficient strategies with the same payoff distributions as some well-known option contracts and this enables us to compute the relative efficiency of these standard contracts. We illustrate the strong connections between cost-efficiency and stochastic dominance.

Number of Pages in PDF File: 32

Keywords: Stochastic Dominance, Efficiency Cost, Expected Utility Optimization, Portfolio Choice

Accepted Paper Series