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by Jun Liu and Jun Pan
This paper studies the optimal investment strategy of an investor who can access not only the bond and the stock markets, but also the derivatives market. We consider the investment situation where, in addition to the usual diusive price shocks, the stock market experiences sudden price jumps and stochastic volatility. The dynamic portfolio problem involving derivatives is solved in closed-form. Our results show that derivatives are important in providing access to the risk and return tradeos associ- ated with the volatility and jump risks. Moreover, as a vehicle to the volatility risk, derivatives are used by non-myopic investors to exploit the time-varying opportunity set; and as a vehicle to the jump risk, derivatives are used by investors to dis-entangle their simultaneous exposure to the diusive and jump risks in the stock market. In addition, derivatives investing also aects investors' stock position because of the in- teraction between the two markets. Finally, calibrating our model to the S&P 500 index and options markets, we nd sizable portfolio improvement for taking advantage of derivatives