Robust Hedging in Incomplete Markets
31 Pages Posted: 10 Feb 2017 Last revised: 28 Feb 2018
Date Written: January 18, 2018
We develop a robust optimal dynamic hedging strategy that takes both downside risks and market incompleteness into account for an agent who fears model misspecification. The robust agent is assumed to minimize the shortfall between the assets and liabilities under an endogenous worst case scenario by means of solving a min-max robust optimization problem. When the funding ratio is low, robustness reduces the demand for risky assets. However, cherishing the hope of covering the liabilities, a substantial risk exposure is still optimal. A longer investment horizon or a higher funding ratio weakens the investor’s fear of model misspecification. If the expected equity return is overestimated, the initial capital requirement for hedging can be decreased by following the robust strategy.
Keywords: Model misspecification, robust optimization, uncertainty set, incomplete market, dynamic hedging, explicit finite difference, expected shortfall
JEL Classification: G11; G13
Suggested Citation: Suggested Citation