Creating Synthetic Option Strategies for Asset Allocation with Transaction Costs Using Multi-Period Stochastic Programming

Abstract

We discuss a new approach to asset allocation with transaction costs. A multi-period stochastic linear programming model is developed where the risk is based on the worst case payoff which is endogenously determined by the model. Utilizing portfolio protection and dynamic hedging, an investment strategy similar to that of a "multiple asset option" on the initial investment portfolio is characterized. The relative changes in the expected terminal wealth, planning target and risk aversion are studied theoretically and illustrated by a numerical example. This model dominates a static mean-variance model when the optimal portfolio is measured by the Sharpe ratio.