We thus assume that the liquid market for certain index-linked catastrophe loss instruments (e.g., cat bonds) is at least large enough to allow the derivation of an exact replicating portfolio
or at least a close approximation.
A comparison of the cost of the replicating portfolio
and the cost of the risk arbitrage strategy will provide us with an estimate of the abnormal returns.
We also test whether a zero cost replicating portfolio
of stock purchases based on Own Country mimicry outperforms a replicating portfolio
of externally copied buy trades.
By constructing a replicating portfolio
, the appraiser is able to back out the option value, or price.
When stated in terms of units of bonds ([[theta].sub.1,] [??]), the replicating portfolio
for the n-period bond answers the question: how many spanning bonds are equivalent to one n-period bond?
Hence it must be synthesized by a dynamic replicating portfolio
invested in a riskfree asset (for instance, T-bills) and in the risky asset.
The returns to the portfolio with dynamic replication will precisely pay off your option obligations, you pocket $2.24, and the desire to capture more of this "free money" will imply that the forces of supply and demand will equate the value of the replicating portfolio
and the option.
To hedge an option, or any risky security, one needs to construct a replicating portfolio
of other securities, one in which the payoffs of the portfolio exactly match the payoffs of the option.
For a forward contract, the replicating portfolio
involves a buy and hold strategy.
This dynamic hedging strategy specifies the composition of the underlying replicating portfolio
. The particular status of the insurance market does not allow to invest in external assets that could provide a perfect hedge of the mortality risk.
The model parameters are estimated at the current time from market prices of traded assets and a replicating portfolio
is established for a particular exotic option based on the model under consideration.
To replicate the tax consequences of the debt, the replicating portfolio
consists of an amount [T.sub.