Dynamic derivative strategies

We study optimal investment strategies given investor access not only to bond and stock markets but also to the derivatives market. The problem is solved in closed form. Derivatives extend the risk and return tradeoffs associated with stochastic volatility and price jumps. As a means of exposure to volatility risk, derivatives enable non-myopic investors to exploit the time-varying opportunity set; and as a means of exposure to jump risk, they enable investors to disentangle the simultaneous exposure to diffusive and jump risks in the stock market. Calibrating to the S&P 500 index and options markets, we find sizable portfolio improvement from derivatives investing. (C) 2003 Elsevier B.V. All rights reserved.