The practice of portfolio replication. A practical overview of forward and inverse problems

Authors: Dembo R.; Rosen D.

Source: Annals of Operations Research, Volume 85, Number 1, 1999 , pp. 267-284(18)

Publisher: Springer

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Abstract:

Portfolio replication is a powerful tool that has proven in practice its applicability toenterprise-wide risk problems such as static hedging in complete and incomplete marketsand markets that gap; strategic asset and capital allocation; benchmark tracking; design ofsynthetic products; and portfolio compression. In this paper, we revise the basic principlesbehind this methodology, currently used by financial institutions worldwide, and presentseveral practical examples of its application. We further show how inverse problems infinance can be naturally formulated in this framework. In contrast to mean-variance optimization,the scenario approach allows for general non-normal, discrete and subjectivedistributions, as well as for the accurate modeling of the full range of nonlinear instruments,such as options. It also provides an intuitive, operational framework for explaining basicfinancial theory.

Language: English

Document Type: Regular paper

Publication date: 1999-01-01