Hedging Options in the Presence of Microstructural Noise

Abstract

In order to use an option pricing model for dynamic hedging an investor will have to calibrate it to a cross-section of option prices. Microstructural noise in option prices results in a set of indistinguishable parametrizations which may give rise to different hedging errors. In our simulation study for the Heston (1993) model, we identify the parameters most important for hedging and show which set of strikes and time to maturity is relevant for the identification of certain parameters. In our empirical study we show that different but indistinguishable parametrizations w.r.t. prices may induce large differences in hedging performance.

Keywords: parameter risk, hedging, microstructural noise, stochastic volatility

JEL Classification: G11, G12