Outperforming benchmarks with their derivatives: theory and empirical evidence

ABSTRACT Recent literature has demonstrated the existence of an unbounded risk premium if one combines the most important models for pricing and hedging derivatives with;coherent risk measures. There may exist combinations of derivatives (good deals) whose pair (return risk) converges to the pair (+∞, −∞). This paper goes beyond;existence properties and looks for optimal explicit constructions and empirical tests. It will be shown that the optimal good deal above may be a simple portfolio of options. This theoretical finding will enable us to implement empirical experiments involving three international stock index futures (Standard & Poor's 500, Eurostoxx 50 and DAX 30) and three commodity futures (gold, Brent and the Dow Jones-UBS Commodity Index). According to the empirical results, the good deal always outperforms the underlying index/commodity. The good deal is built in full compliance with the standard derivative pricing theory. Properties of classical pricing models totally inspire the good deal construction. This is a very interesting difference in our paper with respect to previous literature attempting to outperform a benchmark.