The Ex-Ante Rebalancing Premium

Abstract

The paper focuses on the rebalancing premium, defined as the difference between the cash-flows generated by a fixed-weight (FW) strategy and a drift-weight (DW) strategy at the end of an investment horizon. A unified framework is used to investigate both FW contrarian (long-only) strategies and FW momentum (leveraged and short) strategies. The benefit of the derivatives approach is to provide information about the ex-ante costs of rebalancing.The paper shows that the rebalancing premium can be replicated by a portfolio of derivatives composed of strangles. It introduces the concept of “rebalancing swap,” “rebalancing swap rate,” and “portable rebalancing strategy.”Finally, the paper suggests a “rebalancing factor” to control for the impact of rebalancing in the empirical tests of asset pricing models and mutual fund performance.