A replicating portfolio is a collection of assets that are put together to match a target asset. The portfolio is designed so that the changes in value of the replicating portfolio and the target asset match. A replicating portfolio is also known as a synthetic asset.
The purpose of a replicating portfolio is to reduce risk and create a reliable source of profit. To create profit, as the value of a target asset changes, the weights of the assets in the replicating portfolio are changed to balance out the change in value of the target asset. This helps to create a consistent profit stream. Developing a replicating portfolio also helps the investor hedge options and reduce financial risk. Utilizing a replicating portfolio has some disadvantages for the investor, which include high fees to maintain the appropriate level balance within the portfolio. When using a static replicating portfolio, the assets are purchased with various expiration dates and strike prices. These elements generally remain the same until the portfolio expires. Static hedging of a target asset can be difficult or require a larger number of assets in the replicating portfolio to achieve the desired weights without incurring the cost of frequent trading to redistribute the asset weights.