Hedging with a Volatility Term Structure

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