Simple Robust Hedging with Nearby Contracts

Abstract:     
Most existing hedging approaches are based on neutralizing risk exposures defined under a pre-specified model. This paper proposes a new, simple, and robust hedging approach based on the affinity of the derivative contracts. As a result, the strategy does not depend on assumptions on the underlying risk dynamics. Simulation analysis under commonly proposed security price dynamics shows that the hedging performance of our methodology based on a static position of three options compares favorably against the dynamic delta hedging strategy with daily rebalancing. A historical hedging exercise on S&P 500 index option further highlights the superior performance of our strategy.

Number of Pages in PDF File: 54

Keywords: Options, Static Hedging, Forward Partial Differential Equation, Local Volatility

JEL Classification: E43, E47, G10, G12, C51

working papers series