Group for Research in Decision Analysis

G-2017-58

Replication methods for financial indexes

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In this paper, we first present a review of statistical tools that can be used in asset management either to track financial indexes or to create synthetic ones. More precisely, we look at two important replication methods: the strong replication, where a portfolio of very liquid assets is created and the goal is to track an actual index with the portfolio, and weak replication, where a portfolio of very liquid assets is created and used to either replicate the statistical properties of an existing index, or to replicate the statistical properties of a custom asset. In addition, for weak replication, the target is not an index but a payoff, and the replication amounts to hedge the portfolio so it is as close as possible to the payoff at the end of each month. For strong replication, the main tools are predictive tools, so filtering techniques and regression play an important role. For weak replication, which is the main topic of this paper, in order to determine the target payoff, the investor has to find or choose the distribution function of the target index or custom index, as well as its dependence with other assets, and use a hedging technique. Therefore, the main tools for weak replication are modeling (estimation and goodness-of-fit) and optimal hedging. For example, an investor could wish to obtain Gaussian returns that are independent of some ETFs replicating the Nasdaq and S&P~500 indexes. In order to determine the dependence of the target and a given number of indexes, we introduce a new class of easily constructed models of conditional distributions called B-vines. We also propose to use a flexible model to fit the distribution of the assets composing the portfolio and then hedge the portfolio in an optimal way. Examples are given to illustrate all the important steps required for the implementation of this new asset management methodology.

, 21 pages