Pricing and Hedging of the European Option Linked to Target Volatility Portfolio
38 Pages Posted: 8 Mar 2016
Date Written: August 1, 2015
Advanced risk management strategies have become popular since they protect the investor's investment from market crashes. The latest risk management strategy is called the target volatility strategy. The target volatility strategy is used in order to maintain a stable realized volatility of a portfolio. The strategy re-balances the allocation of risky asset to non-risky asset in order to protect the portfolio from equity market crashes. This paper provides an extensive analysis of the target volatility portfolios and financial derivatives linked to target volatility portfolios. We demonstrate the performance of target volatility portfolios under different financial models. We also examine the effects of re-balancing frequencies on target volatility portfolios. We focus on the pricing and hedging of the European option linked to target volatility portfolios. In particular, we investigate the impact of stochastic equity asset volatility on the pricing and hedging of the European option linked to target volatility portfolios. We also consider different dynamic hedging strategies and compare their performance.
Keywords: Target volatility portfolio, stochastic volatility, re-balance frequency, EWMA method
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