Model Uncertainty, Recalibration, and the Emergence of Delta-Vega Hedging

Abstract

We study option pricing and hedging with uncertainty about a Black-Scholes reference model which is dynamically recalibrated to the market price of a liquidly traded vanilla option. For dynamic trading in the underlying asset and this vanilla option, delta-vega hedging is asymptotically optimal in the limit for small uncertainty aversion. The corresponding indifference price corrections are determined by the disparity between the vegas, gammas, vannas, and volgas of the non-traded and the liquidly traded options.

Keywords: model uncertainty, recalibration, delta-vega hedging, small uncertainty aversion, asymptotics

JEL Classification: G13, C61, C73