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

Harry M. Kat (Contact Author)

Independent

No Address Available

Ronald C. Heynen

Bank of America - Market Risk Management ( email )

1 Alie Street
London E1 8DE
United Kingdom

Register to save articles to
your library

Register

Paper statistics

Abstract Views
2,138
PlumX Metrics