Journal of Investment Strategies

Risk.net

Enhancing enterprise value by trading options

Dilip B. Madan and Yazid M. Sharaiha

Investment activities are enhanced by a regular positioning in options. Results are presented for the Standard & Poor’s 500 index as the underlying asset. Two base activities, long the index and a dynamic portfolio periodically rebalanced to a 60% equity stake, are considered for enhancement. In each case periodic targets that may involve untraded strikes are formulated. Option positions are sought in traded strikes with a view toward minimizing the capital charge for the risk remaining after the hedge. The capital charge is based on the bid–ask spread of a two-price economy. Stress levels implicit in the two prices are taken to be consistent with risk-neutral valuations falling within the spread. New positions always take account of legacy holdings from previous actions, and all open positions are marked-to-market and delta- hedged. The option-enhanced businesses are valued using required returns, reflecting premiums for down- and upside risk charges as embedded in the bid and ask prices of the two-price economies. Option positioning is observed to add market value.

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