Efficiency Analysis and Option Portfolio Selection

Abstract

The unique characteristics of options enable investors to create nonnormal portfolio return distributions that cannot be replicated with other assets. This analysis explores the power of various investment selection criteria to identify efficient portfolios from investment strategies involving call options and treasury bills, stocks, and covered option writing. The preference structure for strategies incorporating options is compared to traditional stock-fixed income investments, and the importance of options to investor utility maximization is illustrated. This study reveals that rules of stochastic dominance that place few restrictions on investor preference functions and asset return distribution are appropriate criteria by which to rank portfolios containing options and other assets.

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