Hedging with Small Uncertainty Aversion
48 Pages Posted: 3 Jul 2015 Last revised: 17 Apr 2017
Date Written: May 20, 2016
We study the pricing and hedging of derivative securities with uncertainty about the volatility of the underlying asset. Rather than taking all models from a prespecified class equally seriously, we penalise less plausible ones based on their "distance" to a reference local volatility model. In the limit for small uncertainty aversion, this leads to explicit formulas for prices and hedging strategies in terms of the security’s cash gamma.
Keywords: volatility uncertainty, ambiguity aversion, option pricing and hedging, asymptotics
JEL Classification: G13, C61, C73
Suggested Citation: Suggested Citation