Hedged Monte-Carlo: Low Variance Derivative Pricing with Objective Probabilities

11 Pages Posted: 12 Sep 2000

See all articles by Marc Potters

Marc Potters

Capital Fund Management; Capital Fund Management

Jean-Philippe Bouchaud

Capital Fund Management

Dragan Sestovic

Multifactor Analytics and Consulting

Date Written: August 9, 2000

Abstract

We propose a new 'hedged' Monte-Carlo (HMC) method to price financial derivatives, which allows to determine simultaneously the optimal hedge. The inclusion of the optimal hedging strategy allows one to reduce the financial risk associated with option trading, and for the very same reason reduces considerably the variance of our HMC scheme as compared to previous methods. The explicit accounting of the hedging cost naturally converts the objective probability into the 'risk-neutral' one. This allows a consistent use of purely historical time series to price derivatives and obtain their residual risk. The method can be used to price a large class of exotic options, including those with path dependent and early exercise features.

JEL Classification: G12,C15,C63

Suggested Citation

Potters, Marc and Potters, Marc and Bouchaud, Jean-Philippe and Sestovic, Dragan, Hedged Monte-Carlo: Low Variance Derivative Pricing with Objective Probabilities (August 9, 2000). Available at SSRN: https://ssrn.com/abstract=238868 or http://dx.doi.org/10.2139/ssrn.238868

Marc Potters (Contact Author)

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France

Jean-Philippe Bouchaud

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France
+33 1 49 49 59 20 (Phone)

Dragan Sestovic

Multifactor Analytics and Consulting ( email )

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