Hedging Under Model Misspecification: All Risk Factors are Equal, But Some are More Equal than Others ...

The Journal of Futures Markets, Vol. 32, No. 5, 397–430 (2012)

50 Pages Posted: 6 Mar 2008 Last revised: 29 Jan 2013

See all articles by Nicole Branger

Nicole Branger

University of Muenster - Finance Center Muenster

Christian Schlag

Goethe University Frankfurt - Research Center SAFE

Eva Schneider

Goethe University Frankfurt - Department of Finance

Norman Seeger

VU University Amsterdam

Date Written: March 17, 2011

Abstract

It is often difficult to distinguish among different option pricing models that consider stochastic volatility and/or jumps based on a cross-section of European option prices. This can result in model misspecification. We analyze the hedging error induced by model misspecification and show that it can be economically significant in the cases of a delta hedge, a minimum variance hedge, and a delta-vega hedge. Furthermore, we explain the surprisingly good performance of a simple ad-hoc Black-Scholes hedge. We compare realized hedging errors (an incorrect hedge model is applied) and anticipated hedging errors (the hedge model is the true one) and find that there are substantial differences between the two distributions, particularly depending on whether stochastic volatility is included in the hedge model. Therefore, hedging errors can be useful for identifying model misspecification. Furthermore, model risk has severe implications for risk measurement and can lead to a significant misestimation, specifically underestimation, of the risk to which a hedged position is exposed.

Keywords: Hedging, Model Risk, Risk Measurement, Model Identification, Delta Hedge, Delta-Vega Hedge, Minimum-Variance Hedge

JEL Classification: G13

Suggested Citation

Branger, Nicole and Schlag, Christian and Schneider, Eva and Seeger, Norman, Hedging Under Model Misspecification: All Risk Factors are Equal, But Some are More Equal than Others ... (March 17, 2011). The Journal of Futures Markets, Vol. 32, No. 5, 397–430 (2012). Available at SSRN: https://ssrn.com/abstract=1100528 or http://dx.doi.org/10.2139/ssrn.1100528

Nicole Branger

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Christian Schlag

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 33699 (Phone)

Eva Schneider

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Grueneburgplatz 1
Frankfurt am Main, Hessen 60323
Germany
0049-(0)69-798-25178 (Phone)
0049-(0)69-798-22788 (Fax)

HOME PAGE: http://www.finance.uni-frankfurt.de/schlag/index.php?case=wimi2&men=2&id=503&lg=1

Norman Seeger (Contact Author)

VU University Amsterdam ( email )

De Boelelaan 1105
Amsterdam, 1081 HV
Netherlands
+31 20 598 1512 (Phone)

HOME PAGE: http://www.norman-seeger.com

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