Dynamic Derivative Strategies

33 Pages Posted: 5 Feb 2002

See all articles by Jun Liu

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Jun Pan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); National Bureau of Economic Research (NBER); China Academy of Financial Research (CAFR)

Date Written: April 2002

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.

Suggested Citation

Liu, Jun and Pan, Jun, Dynamic Derivative Strategies (April 2002). MIT Sloan Working Paper No. 4334-02, Available at SSRN: https://ssrn.com/abstract=296407 or http://dx.doi.org/10.2139/ssrn.296407

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

Jun Pan (Contact Author)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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