A Comparison of Pricing and Hedging Performances of Equity Derivatives Models

15 Pages Posted: 17 Jul 2017 Last revised: 5 Jan 2018

Date Written: July 11, 2017

Abstract

This paper investigates the pricing/hedging conundrum, i.e. the observation of a mismatch between derivatives models’ pricing and hedging performances, that has so far been under-emphasized as the literature tends to focus on increasingly complicated option pricing models, without adequately addressing hedging performance. Hence, we analyze the ability of the Black-Scholes, Practitioner Black-Scholes, Heston-Nandi and Heston models to Deltahedge a set of call options on the S&P500 index and Apple stock. We extend earlier studies in that we consider the impact of asset dynamics, apply a stringent payoff replication strategy, look at the impact of moneyness at maturity and test for the robustness to the parameters’ calibration frequency and Delta-Vega hedging. The study shows that adding risk factors to a model, such as stochastic volatility, should only be considered in light of the data dynamics. Even then, however, more complicated models generally fare poorly for hedging purposes. Hence, a better fit of a model to option prices is not a good indicator of its hedging performance, and so of its ability to describe the underlying dynamics. This can be understood for reasons of over-fitting. Those findings hint to a potentially appealing hedging-based calibration of models’ parameters, rather than the standard pricing-based one.

Keywords: Option Pricing, Dynamic Hedging, Stochastic Volatility, Payoff Replication, Calibration

JEL Classification: G12, G13

Suggested Citation

Lassance, Nathan and Vrins, Frederic Daniel, A Comparison of Pricing and Hedging Performances of Equity Derivatives Models (July 11, 2017). Applied Economics, Volume 50, Issue 10, pp. 1122-1137, Available at SSRN: https://ssrn.com/abstract=3000405 or http://dx.doi.org/10.2139/ssrn.3000405

Nathan Lassance (Contact Author)

LFIN/LIDAM, UCLouvain ( email )

151 Chaussée de Binche
Mons, 7000
Belgium

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