A Discrete-Time Hedging Framework with Multiple Factors and Fat Tails: On What Matters

38 Pages Posted: 21 Jan 2021

See all articles by Maciej Augustyniak

Maciej Augustyniak

University of Montreal - Department of Mathematics and Statistics

Alex Badescu

University of Calgary

Jean-François Bégin

Simon Fraser University

Date Written: November 11, 2020

Abstract

This article presents a quadratic hedging framework for a general class of discrete-time affine multi-factor models and investigates the extent to which multi-component volatility factors, fat tails, and a non-monotonic pricing kernel can improve the hedging performance. A semi-explicit hedging formula is derived for our general framework which applies to a myriad of the option pricing models proposed in the discrete-time literature. We conduct an extensive empirical study of the impact of modelling features on the hedging effectiveness of S&P 500 options. Overall, we find that fat tails can be credited for half of the hedging improvement observed, while a second volatility factor and a non-monotonic pricing kernel each contribute to a quarter of this improvement. Moreover, our study indicates that the added value of these features for hedging is different than for pricing. A robustness analysis further shows that a similar conclusion can be reached when considering the Dow Jones Industrial Average.

Keywords: option hedging, risk-minimization, affine models, multi-component volatility, exponential affine pricing kernels

JEL Classification: C58, G12, G13

Suggested Citation

Augustyniak, Maciej and Badescu, Alex and Bégin, Jean-François, A Discrete-Time Hedging Framework with Multiple Factors and Fat Tails: On What Matters (November 11, 2020). Available at SSRN: https://ssrn.com/abstract=3728995 or http://dx.doi.org/10.2139/ssrn.3728995

Maciej Augustyniak (Contact Author)

University of Montreal - Department of Mathematics and Statistics ( email )

C.P. 6128, succursale Centre-ville
Montreal, Quebec H3C 3J7
Canada

HOME PAGE: http://dms.umontreal.ca/

Alex Badescu

University of Calgary ( email )

University of Calgary
Calgary, Alberta
Canada

Jean-François Bégin

Simon Fraser University ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

HOME PAGE: http://www.sfu.ca/~jbegin

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