Dynamic Index Tracking and Risk Exposure Control Using Derivatives

Speaker: Tim Leung from UW-Seattle

Date and Time: 03/23/2020,  4-5pm

Abstract: A common challenge faced by many institutional and retail investors is to effectively control risk exposure to various market factors. There is a great variety of indices designed to provide different types of exposures across sectors and asset classes. Some of these indices can be difficult or impossible to trade directly, but investors can trade the associated financial derivatives if they are available in the market. For example, the CBOE Volatility Index (VIX), often referred to as the fear index, is not directly tradable, but investors can gain exposure to the index and potentially hedge against market turmoil by trading futures and options written on VIX.

We develop a methodology for index tracking and risk exposure control using financial derivatives. Under a continuous-time diffusion framework for price evolution, we present a pathwise approach to construct dynamic portfolios of derivatives in order to gain exposure to an index and/or market factors that may be not directly tradable. A general tracking condition is established to relate the portfolio drift to the desired exposure coefficients under any given model. We derive the slippage process that reveals how the portfolio return deviates from the targeted return. In our multi-factor setting, the portfolio’s realized slippage depends not only on the realized variance of the index, but also the realized covariance among the index and factors. Trading strategies are implemented under a number of models using different derivatives, such as futures and options.

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