Dynamic Mis-Specification in Local-Stochastic Volatility Models
13 Pages Posted: 8 May 2009 Last revised: 1 Jun 2009
Date Written: May 5, 2009
Abstract
In the context of interest rate derivatives, we present two simple cases of replication error associated with common hedging strategies when agents have partial information about the real dynamics of the underlying asset. In particular, we derive an explicit expression for the hedging error due to model mis-specification in the following cases, i) the trader delta-hedges his option position in the Black and Scholes framework with stochastic implied volatilities, and ii) the trader uses a given local-stochastic volatility model to delta and vega hedge his/her option exposure but the real dynamics of the underlying follow a different local-stochastic volatility process.
Keywords: Replication error, model selection, local and stochastic volatility modelling, implied stochastic volatility
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
Theory and Calibration of Swap Market Models
By Stefano Galluccio, O. Scaillet, ...
-
Monte Carlo Market Greeks in the Displaced Diffusion LIBOR Market Model
By Mark S. Joshi and Oh Kang Kwon
-
Effective Implementation of Generic Market Models
By Mark S. Joshi and Lorenzo Liesch
-
By Nick Denson and Mark S. Joshi
-
Fast and Accurate Greeks for the Libor Market Model
By Nick Denson and Mark S. Joshi
-
Fast Delta Computations in the Swap-Rate Market Model
By Mark S. Joshi and Chao Yang