Pricing and Hedging of Discrete Dynamic Guaranteed Funds

26 Pages Posted: 10 Mar 2008

See all articles by Wai-Man Tse

Wai-Man Tse

affiliation not provided to SSRN

Eric C. Chang

University of Hong Kong - School of Business

Leong Kwan Li

affiliation not provided to SSRN

Henry M. K. Mok

affiliation not provided to SSRN

Abstract

We derive a risk-neutral pricing model for discrete dynamic guaranteed funds with geometric Gaussian underlying security price process. We propose a dynamic hedging strategy by adding a gamma factor to the conventional delta. Simulation results demonstrate that, when hedging discretely, the risk-neutral gamma-adjusted-delta strategy outperforms the dynamic delta hedging strategy by reducing the expected hedging error, lowering the hedging error variability, and improving the self-financing possibility. The discrete dynamic delta-only hedging not only causes potential overcharge to clients but also could be costly to the issuers. We show that a naive application of continuous-time hedging formula to a discrete-time hedging setting tends to worsen these possibilities.

Suggested Citation

Tse, Wai-Man and Chang, Eric Chieh C. and Li, Leong Kwan and Mok, Henry M. K., Pricing and Hedging of Discrete Dynamic Guaranteed Funds. Journal of Risk & Insurance, Vol. 75, Issue 1, pp. 167-192, March 2008. Available at SSRN: https://ssrn.com/abstract=1103704 or http://dx.doi.org/10.1111/j.1539-6975.2007.00253.x

Wai-Man Tse (Contact Author)

affiliation not provided to SSRN

Eric Chieh C. Chang

University of Hong Kong - School of Business ( email )

Meng Wah Complex
Pokfulam Road
Hong Kong
China

Leong Kwan Li

affiliation not provided to SSRN

Henry M. K. Mok

affiliation not provided to SSRN

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