Replicating Portfolio

A replicating portfolio is a collection of financial assets or securities designed to mimic the behavior or risk-return profile of another asset or portfolio, such as an option or a complex investment strategy. By holding a replicating portfolio, investors can hedge or replicate the performance of a target asset without directly holding the asset itself. This strategy is commonly used in options pricing models and for managing financial risks, such as those related to insurance liabilities.

Example

An investor creates a replicating portfolio of stocks and bonds to mimic the risk-return profile of an option, allowing them to hedge against potential market movements without holding the option itself.