Simple Robust Hedging with Nearby Contracts
54 Pages Posted: 2 Nov 2010
Date Written: November 2, 2010
Most existing hedging approaches are based on neutralizing risk exposures defined under a pre-specified model. This paper proposes a new, simple, and robust hedging approach based on the affinity of the derivative contracts. As a result, the strategy does not depend on assumptions on the underlying risk dynamics. Simulation analysis under commonly proposed security price dynamics shows that the hedging performance of our methodology based on a static position of three options compares favorably against the dynamic delta hedging strategy with daily rebalancing. A historical hedging exercise on S&P 500 index option further highlights the superior performance of our strategy.
Keywords: Options, Static Hedging, Forward Partial Differential Equation, Local Volatility
JEL Classification: E43, E47, G10, G12, C51
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