Optimal Hedging When the Underlying Asset Follows a Regime-Switching Markov Process

34 Pages Posted: 17 Aug 2012 Last revised: 19 Aug 2012

See all articles by Pascal Francois

Pascal Francois

HEC Montreal - Department of Finance

Geneviève Gauthier

Department of decision Sciences and GERAD; Associate member, Oxford-Man Institute (OMI)

Frédéric Godin

Concordia University, Quebec - Department of Mathematics & Statistics

Date Written: August 16, 2012

Abstract

We develop a flexible discrete-time hedging methodology that miminizes the expected value of any desired penalty function of the hedging error within a general regime-switching framework. A numerical algorithm based on backward recursion allows for the sequential construction of an optimal hedging strategy. Numerical experiments comparing this and other methodologies show a relative expected penalty reduction ranging between 0.9% and 12.6% with respect to the best benchmark.

Keywords: Dynamic programming, hedging, risk management, regime switching

JEL Classification: G32, C61

Suggested Citation

Francois, Pascal and Gauthier, Genevieve and Godin, Frédéric, Optimal Hedging When the Underlying Asset Follows a Regime-Switching Markov Process (August 16, 2012). 25th Australasian Finance and Banking Conference 2012, Available at SSRN: https://ssrn.com/abstract=2130822 or http://dx.doi.org/10.2139/ssrn.2130822

Pascal Francois

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
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514-340-7743 (Phone)
514-340-5632 (Fax)

Genevieve Gauthier (Contact Author)

Department of decision Sciences and GERAD ( email )

3000 Côte-Sainte-Catherine Road
Montreal, QC H2S1L4
Canada

Associate member, Oxford-Man Institute (OMI) ( email )

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Oxford, Oxfordshire OX2 6ED
United Kingdom

Frédéric Godin

Concordia University, Quebec - Department of Mathematics & Statistics ( email )

1455 De Maisonneuve Blvd. W.
Montreal, Quebec H3G 1M8
Canada

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