Research and White Papers
Private equity (“PE”) is known for the attractive return potential it offers to institutional investors. Yet, investors often face a timing issue when investing with PE managers. While capital is committed to a PE fund at one point in time, it is generally called over an extended period. A recent study by Preqin1 shows that the amount of “dry powder”, i.e. the amount of committed capital that has not yet been called and is “parked” in liquid assets, has increased by nearly 50% since December 2012. In this paper, we discuss the use of option-based strategies to create synthetic PE exposure as committed capital waits to be deployed.
"The Recovery Theorem." Ross, Stephen A. Journal of Finance Vol. 70 o. 2 (2015): 615-648
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We can only estimate the distribution of stock returns, but from option prices we observe the distribution of state prices. State prices are the product of risk aversion - the pricing kernel - and the natural probability distribution. The Recovery Theorem enables us to separate these to determine the market's forecast of returns and risk aversion from state prices alone. Amoung other things, this allows us to recover the pricing kernel, market risk premium, and probability of a catastrophe and to construct model-free tests of the efficient market hypothesis.
Asset reallocation, or moving capital across asset risk classes, is commonly used to modify equity exposure in an investment portfolio. However, what comes with the lower risk is lower expected return and by reallocating to low risk asset classes, investors are giving up some of the upside potential if equity investment in exchange for directly proportional downside protection.
An alternative approach to asset allocation in general and to modifying equity exposure in particular is to add an option overlay portfolio to an unchagned equity portfolio. The non-linear nature of the option payoff profile may allow investors to achieve the same level of downside protection without giving up as much upside potential as in the asset reallocation approach. There are no free lunches though and the relevant tradeoff is between the advantages of the risk-return profile provided by options against the cost of the options used to implement the risk profile.
In this paper, we outline a framework to evaluate and compare the two approaches, and to inform a decision.