Dynamic Index Tracking and Risk Exposure Control Using Derivatives
Applied Mathematical Finance, August 2018
26 Pages Posted: 30 May 2017 Last revised: 27 Feb 2019
Date Written: June 8, 2017
We develop a methodology for index tracking and risk exposure control using financial derivatives. Under a continuous-time diffusion framework for price evolution, we present a pathwise approach to construct dynamic portfolios of derivatives in order to gain exposure to an index and/or market factors that may be not directly tradable. Among our results, we establish a general tracking condition that relates the portfolio drift to the desired exposure coefficients under any given model. We also derive a slippage process that reveals how the portfolio return deviates from the targeted return. In our multi-factor setting, the portfolio's realized slippage depends not only on the realized variance of the index, but also the realized covariance among the index and factors. We implement our trading strategies under a number of models, and compare the tracking strategies and performances when using different derivatives, such as futures and options.
Keywords: slippage, index tracking, exposure control, realized covariance, derivatives trading
JEL Classification: G11, G13
Suggested Citation: Suggested Citation