Smile-Implied Hedging with Volatility Risk

37 Pages Posted: 16 Oct 2020

See all articles by Pascal Francois

Pascal Francois

HEC Montreal - Department of Finance

Lars Stentoft

Department of Economics, University of Western Ontario; Center for Interuniversity Research and Analysis on Organization (CIRANO); Aarhus University - CREATES

Date Written: August 26, 2020

Abstract

Options can be dynamically replicated using model-free Greeks extracted from the volatility smile. However, smile-implied delta and delta-gamma hedging do not achieve minimum variance in the presence of price-volatility correlation, and these strategies have shown poor performance relative to the Black-Scholes benchmark. We propose a way to extend smile-implied option replication with volatility risk management. Large-scale evidence on S&P 500 index options indicates that smile-implied delta-gamma-vega hedging strategies outperform the Black-Scholes approach as well as more sophisticated option hedging frameworks including stochastic volatility and jumps.

Keywords: Options, Hedging, Volatility smile, Stochastic implied volatility

JEL Classification: G13

Suggested Citation

Francois, Pascal and Stentoft, Lars, Smile-Implied Hedging with Volatility Risk (August 26, 2020). Available at SSRN: https://ssrn.com/abstract=3681662 or http://dx.doi.org/10.2139/ssrn.3681662

Pascal Francois (Contact Author)

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada
514-340-7743 (Phone)
514-340-5632 (Fax)

Lars Stentoft

Department of Economics, University of Western Ontario ( email )

London, Ontario N6A 5B8
Canada

Center for Interuniversity Research and Analysis on Organization (CIRANO)

2020 rue University, 25th floor
Montreal H3C 3J7, Quebec
Canada

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

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