RESEARCH PAPER NO. 829

THE CHEAPEST HEDGE:A PORTFOLIO DOMINANCE APPROACH

by

C. D. Aliprantis & I. A. Polyrakis & R. Tourky

JANUARY 2002

Department of Economics. University of Melbourne. Melbourne Victoria 3010 Australia

ABSTRACT

Investors often wish to insure themselves against the payoff of their portfolios falling below a certain value. One way of doing this is by purchasing an appropriate collection of traded securities. However, when the derivatives market is not complete, an investor who seeks portfolio insurance will also be interested in the cheapest hedge that is marketed. Such insurance will not exactly replicate the desired insured-payoff, but it is the cheapest that can be achieved using the market.

Analytically, the problem of finding a cheapest insuring portfolio is a linear programming problem. The present paper provides an alternative portfolio dominance approach to solving the minimum-premium insurance portfolio problem. This affords remarkably rich and intuitive insights to determining and describing the minium premium insurance portfolios.

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