Portfolio Management Framework for Derivative Instruments
9 Pages Posted: 25 Sep 2022 Last revised: 26 Dec 2023
Date Written: September 14, 2022
Abstract
The investment industry lacks a unified framework for handling derivative instruments in general portfolio management. With the increased use of derivatives, there is a need for a framework that aligns fundamental terminology and concepts. The main challenges with the current practices are caused by an improper separation of exposure / notional and market value / price. This tendency is also seen in the academic literature where exposures and prices are usually treated as identical quantities, e.g., in portfolio optimization. This article proposes a simple framework that can be used for all aspects of portfolio management and has intuitive properties that align with current conventions related to portfolio return. The framework allows us to perform portfolio optimization, risk decomposition, and performance evaluation in a familiar way.
Documented Python code that replicates the results of the case study is available in the open-source package fortitudo.tech. More information about the package can be found on https://os.fortitudo.tech.
Keywords: Portfolio management, derivative instruments, leverage, portfolio optimization, performance evaluation, CVaR, tail risks, market views, stress-testing, Entropy Pooling, Kullback-Leibler divergence.
JEL Classification: B16, B26, C02, C61, C63, C65, C88, G00, G10, G11, G13, G17.
Suggested Citation: Suggested Citation