capture Equity premium with derivatives


1 0

I recently had a chance to look through the asset allocation of equity funds, which are targeted at conservative investors. Lots them start with a target allocation for (1-a) equity and an allocation of a in derivatives (plus maybe a small amount of cash).

Now what I don't understand is why the asset allocation to derivatives (mostly calls, so not downside protection).
I see only two justification in the underlying thinking of a portfolio manager (which both don't reasonable to me)

a.) he believes he can outperform the market through title selection, i.e. he believes the derivatives are underpriced


b.) you can capture the equity premium with derivatives.

For a.) fair enough. For b.) here I am not sure. Generally option pricing assumes brownian motion with a constant vola and drift. Or in other words, correct me if I am wrong - skewed returns to the right - the equity premium, which should be priced in call (make them more expensive) and make puts cheaper.
Another argument, why you can' t capture the equity premium: Options are a zero sum game, so capturing the equity premium with derivatives is not possible by definition.

Now based on this only a.) gives a valid justification to put call options in your portfolio doesn't it?
Is my line of argument valid in b?



Thermal Ebb

Active member
100 15
Daniel, don't know how deep you want to get into this, but checkout both Brennan and Liu who have done outstanding work in this area.

Your question can't be answered for the general case as the specific risk profile and performance requirements of the fund must be directly factored. It's a beautiful thing to be getting into and I recommend you do further research, but it'll eat your research hours up unless you get your supervisor to channel your focus to a couple of simple real-world examples. I assume you're doing this for a PhD.
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