A NEW HEDGE FUND REPLICATION METHOD WITH THE DYNAMIC OPTIMAL PORTFOLIO

This paper provides a new hedge fund replication method, which extends Kat and Palaro (2005) and Papageorgiou, Remillard and Hocquard (2008) to multiple trading assets with both long and short positions. The method generates a target payoff distribution by the cheapest dynamic portfolio. The work here extends the work of of Dybvig (1988) to a continuous-time framework and dynamic portfolio optimization where the dynamic trading strategy is derived analytically by applying Malliavin calculus. It is shown that cost minimization is equivalent to maximization of a certain class of von Neumann-Morgenstern utility functions. The method is applied to the replication of a CTA/Managed Futures Index in practice.