Pricing and Hedging Gap Risk

21 Pages Posted: 5 Sep 2008 Last revised: 10 Oct 2008

Date Written: September 4, 2008

Abstract

We analyze a new class of exotic equity derivatives called gap options or gap risk swaps. These products are designed by major banks to sell off the risk of rapid downside moves, called gaps, in the price of the underlying. We show that to price and manage gap options, jumps must necessarily be included into the model, and present explicit pricing and hedging formulas in the single asset and multi-asset case. The effect of stochastic volatility is also analyzed.

Keywords: Gap risk, gap option, exponential Levy model, quadratic hedging, Levy copula

JEL Classification: G13

Suggested Citation

Tankov, Peter, Pricing and Hedging Gap Risk (September 4, 2008). Available at SSRN: https://ssrn.com/abstract=1263352 or http://dx.doi.org/10.2139/ssrn.1263352

Peter Tankov (Contact Author)

ENSAE Paris ( email )

92245 Malakoff Cedex
France
91400 (Fax)

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