Explicit Representation of Cost-Efficient Strategies

32 Pages Posted: 22 Oct 2010

See all articles by Carole Bernard

Carole Bernard

Grenoble Ecole de Management; Vrije Universiteit Brussel (VUB)

Phelim P. Boyle

Wilfrid Laurier University - School of Business & Economics; University of Waterloo

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Date Written: May 12, 2010

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.

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

Suggested Citation

Bernard, Carole and Boyle, Phelim P., Explicit Representation of Cost-Efficient Strategies (May 12, 2010). Paris December 2010 Finance Meeting EUROFIDAI - AFFI, Available at SSRN: https://ssrn.com/abstract=1695543

Carole Bernard (Contact Author)

Grenoble Ecole de Management ( email )

12, rue Pierre Sémard
Grenoble Cedex, 38003
France

Vrije Universiteit Brussel (VUB) ( email )

Pleinlaan 2
http://www.vub.ac.be/
Brussels, 1050
Belgium

Phelim P. Boyle

Wilfrid Laurier University - School of Business & Economics ( email )

Waterloo, Ontario N2L 3C5
Canada
519 884 1970 (Phone)
519 888 1015 (Fax)

University of Waterloo

Waterloo, Ontario N2L 3G1
Canada

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