Using examples, explain how the concept of tracking (or

replicating) portfolios is relevant for factor models and for

binomial option pricing.
Factor Models and Tracking Portfolios

We may want to identify an alternative to an asset (or

portfolio of assets) that has the same expected return profile

Applications include
Risk analysis (expressing the risk of our chosen
asset in terms of the risk of assets which are better
understood)
Hedging (we could use the other assets to
hedge the risk on our chosen asset)
Portfolio management (factor bets we may
want to take on only part of the risk exposure of our chosen
asset)

If we can identify portfolios that behave like each of the

Factors in our pricing model, we can combine this with the
Factor Betas for our chosen asset to identify a portfolio that
will track that asset

Identifying Tracking Portfolios

The tracking portfolio needs to have the same sensitivity to

each Factor as the asset we are tracking

To find the tracking portfolio, we need the expected return

equation from our factor model for our Target Asset, together
with the equivalent equations for the assets we are going to
use in our tracking portfolio

we need at least one more asset (to include in the tracking

portfolio) than Factor in our model at least 2 assets to solve
for a tracking portfolio in a 1- Factor model At least 3

assets to solve for a tracking portfolio in a 2- Factor model,

and so on

Zero Factor Betas & the Risk-Free Return

in our example, the for the tracking portfolio and the
target asset are equal (=0.09)
LAW OF ONE PRICE if they were different, an arbitrage
opportunity would exist we could buy the target asset and
sell the tracking
portfolio (or vice-versa) to lock in a guaranteed profit
must be the risk-free return
The Factor Betas represent additional return for Factor Risk
is the expected return where all the Factor Betas are
zero, so it must be the risk-free return

for example refer to slides 19 and 20 topic 3

Slide 21-29 topic 4