The Practice of Portfolio Replication 1

It is now widely recognized by financial institutions and regulatory bodies that an effective risk management function must be organized on an enterprise-wide basis, and must cover all aspects of risk in the financial markets. It is no longer sufficient to manage risk primarily at the local levels. Enterprise-wide risk management (EWRM) refers to the set of policies and procedures put in place to monitor, control and manage all financial risks of an institution in a unified way. In addition to monitoring risk, an effective risk management function must help the firm understand the sources of its exposures, restructure its risk profile, and obtain optimal risk versus profit trade-offs, within and across various business lines. Portfolio replication is a powerful, robust methodology that can be used to address these issues generally within an EWRM and portfolio management framework. Its applications include• strategic (firm-wide) and tactical asset and capital allocation• risk restructuring• benchmark tracking• selection of efficient investment portfolios• hedging and pricing in complete and incomplete markets• portfolio compression• estimation of implied no-arbitrage parameters and implied views (inverse problems). Not only does the technique naturally accommodate general (non-normal) distributions and nonlinear instruments (such as options), but it also explicitly models discrete markets that we often observe in practice, where trading may be costly and liquidity limited. The methodology also naturally accommodates transaction costs, liquidity and other specified user constraints as well as investor preferences.In this paper, we review the basic principles behind this methodology currently used by