A recent body of work extends the replicating portfolio approach to provide insights into valuation and measurement of key assets and entities of interest. In this post, I discuss some innovative examples that are worth noting.
Here are some common problems in finance research:
Recent series of papers tackle these questions using an old idea embedded in option pricing: the replicating portfolio approach. Below I discuss some useful examples.
Gupta and Van Nieuwerburgh (2021) estimate the risk-adjusted profits of private equity (PE) by netting out the returns of a replicating portfolio. Risk-adjusting for PE is very difficult given the irregularity of the observed cash flows and relative lack of transparency. The "standard" methods in the industry either do not adjust for risk (e.g. IRR) or only consider aggregate stock market risk.
Their innovation here is to construct a replicating portfolio that embodies the risk inherent in the cash flows of a PE investment.
To do so, they first estimate the exposure of PE funds’ cash-flows to the cash-flows of a set of publicly listed securities including stocks, REITs, infrastructure stocks, and natural resource stocks. This is essentially amounts to the loadings on the "basis assets" of the replicating portfolio. They then use an asset pricing model to price the time-series and the cross-section of zero-coupon bonds and equity strips. Together with the earlier result, they are able to compute the price of the replicating portfolio.