Pricing and Hedging Power Options

Financial Engineering and the Japanese Market, Vol. 3, No. 3, September 1996

Cass Business School Research Paper

Posted: 1 Jun 2001

See all articles by Harry M. Kat

Harry M. Kat

Independent

Ronald C. Heynen

Bank of America - Market Risk Management

Abstract

In this article we study the pricing and hedging of options whose payoff is a polynomial function of the underlying reference index at expiration; so-called power options. Working in the Black-Scholes (1973) framework, we derive closed-form formulas for the prices of general power calls and puts. Parabola options are studied as a special case. Power options can be hedged by statically combining ordinary options in such a way that their payoffs form a piecewise linear function that approximates the power option's payoff. Traditional delta hedging may subsequently be used to reduce any residual risk.

JEL Classification: G13

Suggested Citation

Kat, Harry M. and Heynen, Ronald C., Pricing and Hedging Power Options. Financial Engineering and the Japanese Market, Vol. 3, No. 3, September 1996, Cass Business School Research Paper, Available at SSRN: https://ssrn.com/abstract=265013

Ronald C. Heynen

Bank of America - Market Risk Management ( email )

1 Alie Street
London E1 8DE
United Kingdom

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