An Explicit Option - Based Strategy that Outperforms Dollar Cost Averaging

19 Pages Posted: 26 Jul 2011 Last revised: 23 Aug 2011

Steven Vanduffel

Vrije Universiteit Brussel (VUB)

Ales Ahcan

University of Ljubljana - Faculty of Economics

Luc Henrard

BNP Paribas

Mateusz Maj

Vrije Universiteit Brussel (VUB) - Faculty of Economic, Social and Political Sciences

Date Written: July 26, 2011

Abstract

Dollar cost averaging (DCA) is a widely employed investment strategy in financial markets. At the same time it is also well documented that such gradual policy is sub-optimal from the point of view of risk averse decision makers with a fixed investment horizon T > 0. However, an explicit strategy that would be preferred by all risk averse decision makers did not yet appear in the literature.

In this paper we give a novel proof for the sub-optimality of DCA when (log) returns are governed by Lévy processes and we construct a dominating strategy explicitly. The optimal strategy we propose is static and consists in purchasing a suitable portfolio of path - independent options.

Next, we discuss a market governed by a Brownian motion in more detail. We show that the dominating strategy amounts to setting up a portfolio of power options. We provide evidence that the relative performance of DCA becomes worse in volatile markets, but also give some motivation to support its use. We also analyze DCA in presence of a minimal guarantee, explore the continuous setting and discuss the (non) uniqueness of the dominating strategy.

Keywords: lévy process, minimal guarantee, Jensen's inequality, Brownian Bridge, hedging, Esscher transform

Suggested Citation

Vanduffel, Steven and Ahcan, Ales and Henrard, Luc and Maj, Mateusz, An Explicit Option - Based Strategy that Outperforms Dollar Cost Averaging (July 26, 2011). International Journal of Theoretical and Applied Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1895344

Steven Vanduffel (Contact Author)

Vrije Universiteit Brussel (VUB) ( email )

Pleinlaan 2
Brussels, Brabant 1050
Belgium

HOME PAGE: http://www.stevenvanduffel.com

Ales Ahcan

University of Ljubljana - Faculty of Economics ( email )

Kardeljeva ploscad 17
Ljubljana, 1000
Slovenia

Luc Henrard

BNP Paribas ( email )

Montagne Du Parc 3
Belgium

Mateusz Maj

Vrije Universiteit Brussel (VUB) - Faculty of Economic, Social and Political Sciences ( email )

Ave. Franklin D Roosevelt, 50 - C.P. 191
B-1050 Brussels
Belgium

Paper statistics

Downloads
194
Rank
127,515
Abstract Views
927