Hedging with a Volatility Term Structure

THE JOURNAL OF DERIVATIVES, Vol 2 No 3, Spring 1995

Posted: 4 Nov 1998

See all articles by Michel Crouhy

Michel Crouhy

Canadian Imperial Bank of Commerce - Risk Management

Dan Galai

Hebrew University of Jerusalem - Jerusalem School of Business Administration

Abstract

Because of transaction costs and other execution problems, hedging portfolios are readjusted only periodically, usually once a day. The question is whether the hedge ratio should reflect the instantaneous variance, the average variance over the life of the option as in the Black-Scholes model, or a combination of the two volatility measures. In this article, the authors show that for path-independent options the option value depends only on the average volatility, while the hedge ratio depends also on the path of future volatility. The sensitivity of the hedge ratio to short-term volatility depends on the degree of moneyness of the option. This is shown to be a more serious problem for short-term than for long-term options.

JEL Classification: G10

Suggested Citation

Crouhy, Michel and Galai, Dan, Hedging with a Volatility Term Structure. THE JOURNAL OF DERIVATIVES, Vol 2 No 3, Spring 1995. Available at SSRN: https://ssrn.com/abstract=6244

Michel Crouhy (Contact Author)

Canadian Imperial Bank of Commerce - Risk Management ( email )

Dan Galai

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel
972 2 5883235 (Phone)
972 2 5881341 (Fax)

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