What is a replicating strategy?

A man with a briefcase in his hand climbing up a bar chart

The replicating strategy is explained as a way that traders use to find the value of an asset by replicating its cash flow and price movement using other assets whose values they know.

Traders mainly use this strategy to hedge the risk exposure that comes with writing options. To achieve the same payoff, traders use the strategy to shift a portfolio's exposure between less risky and riskier assets, or between two or more risky assets.

Tarunkumar Maheshchandra Mishra, Master of Business Administration (MBA) at the California State University, Sacramento, said that replication strategy of an option is used to realise the same payoff that could have been realised by holding a position in the option itself when the target option is not available.

What does replicating strategy mean? In order to ensure that a portfolio’s market value does not decrease beyond a certain level, it’s necessary to insure it by hedging with options, Mishra wrote in the thesis.

The replicating strategy definition by GlobalCapital, as explained in its article of 23 March 1998, notes:

“Investors and traders use options to gain or reduce exposure, change portfolio structure, enhance returns and enact arbitrage strategies. And they want portfolios that have some degree of flexibility to gain unlimited upside potential at a fixed downside cost. ”

“A replicating strategy can be a viable alternative for investors wishing to obtain a fairly-priced option like asset.”

There are three types of replication strategy commonly used by asset managers: Delta, Gamma and Vega – also known as the ‘Greeks’. They help to assess options risk and manage option portfolios.

How does replicating strategy work?

The replicating strategy, also known as a dynamic trading strategy, uses exchange traded assets that have the same net profit. This strategy is used by traders to replicate an asset's price movement in terms of other assets whose values they already know, in order to price or model the assets.

An example of replicating strategy is when traders replicate the cash flows of an inverse floating rate bond with spread by using a combination of floating rate bonds, coupon bonds and zero-coupon bonds.

Another replicating strategy example is using the delta replication. The option model provides a hedge ratio or delta which indicates how much the option price changes as the underlying assets change.

For example, a delta of 0.5 indicates that for every $1 change in the underlying asset, the option price will change by $ 0.50.

The replicating portfolio method is related to a super-hedging strategy that is aimed to help investors build a profitable portfolio regardless of the market’s upward and downward movements.

FAQs

How does replicating strategy work?

Replicating strategy is used to find the value of an asset by replicating its cash flow and price movement using other assets whose values are already known. It’s known as a dynamic trading strategy, and usually involves exchange traded assets with the same net profit.

How many types of replicating strategy are there?

There are three main types of replication strategy that are commonly used by asset managers: Delta, Gamma and Vega – or known as the ‘Greeks’, according to GlobalCapital.