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Derivatives in Portfolio Management: Why Beating the Market is Easy

Under the efficient market hypothesis, overwriting calls or purchasing insurance should not improve risk-adjusted portfolio returns. A proper analysis should show that if options are traded at a fair cost, the risk-reward characteristics of an option position would fall on the efficient market line. In this paper we show that, due to several limitations of mean-variance analysis, this is not the case in practice. We quantify and identify the nature of the resulting biases for performance evaluation, and explain why alternative measures such as semi variance do not help in avoiding such biases. A revisited version of this paper was published in the Winter, 7(2) issue of Derivatives Quarterly.

Author(s) :

François-Serge Lhabitant

Summary :

Under the efficient market hypothesis, overwriting calls or purchasing insurance should not improve risk-adjusted portfolio returns. A proper analysis should show that if options are traded at a fair cost, the risk-reward characteristics of an option position would fall on the efficient market line. In this paper we show that, due to several limitations of mean-variance analysis, this is not the case in practice. We quantify and identify the nature of the resulting biases for performance evaluation, and explain why alternative measures such as semi variance do not help in avoiding such biases. A revisited version of this paper was published in the Winter, 7(2) issue of Derivatives Quarterly.

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Type : Working paper
Date : 11/01/2000
Keywords :

Performance