A New Set of Financial Instruments
20 Pages Posted: 26 Nov 2019
Date Written: November 14, 2019
In complete markets, there are risky assets and a riskless asset. It is assumed that the riskless asset and the risky asset are traded continuously in time and that the market is frictionless. In this paper, we propose a new method for hedging derivatives assuming that a hedger should not always rely on trading existing assets that are used to form a linear portfolio comprised of the risky asset, the riskless asset, and standard derivatives, but rather should design a set of specific, most-suited financial instruments for the hedging problem. We introduce a sequence of new financial instruments best suited for hedging jump-diffusion and stochastic volatility market models. The new instruments we introduce are perpetual derivatives. More specifically, they are options with perpetual maturities. In a financial market where perpetual derivatives are introduced, there is a new set of partial and partial-integro differential equations for pricing derivatives. Our analysis demonstrates that the set of new financial instruments together with a risk measure called the tail-loss ratio measure defined by the new instrument's return series can be potentially used as an early warning system for a market crash.
Keywords: option pricing, hedging, Merton's jump diffusion model, stochastic volatility model, tail-loss ratio risk measure
JEL Classification: G10, G12, G13
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