Bridge over ocean
1 September 2007 Financial Analysts Journal Volume 63, Issue 5

Rebalancing Revisited: The Role of Derivatives

  1. David P. Brown
  2. Gideon Ozik
  3. Daniel Scholz

Portfolio rebalancing trades off tracking error against the transaction costs associated with avoiding tracking error. Prior analytical work derived optimal rebalancing strategies that minimize the expected transaction costs required to achieve a given level of tracking error. Using these strategies results in the same level of tracking error as naive strategies often observed in practice but with much lower transaction costs. Additional (substantial) reductions in expected transaction costs can be obtained by using derivatives to synthetically rebalance a portfolio. The design of an efficient synthetic rebalancing program, however, is complicated. This article describes the key elements in such a complex design.

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