Static Options Replication

JOURNAL OF DERIVATIVES, Vol 2 No 4

Posted: 11 Nov 2000

See all articles by Emanuel Derman

Emanuel Derman

Columbia University

Deniz Ergener

Merrill Lynch

Iraj Kani

Samson Capital Advisors; Columbia University - Department of Industrial Engineering and Operations Research (IEOR)

Abstract

This article presents a practical and useful method for replicating or hedging a target stock option with a portfolio of other options. It shows how to construct a replicating portfolio of standard options with varying strikes and maturities and fixed portfolio weights. Once constructed, this portfolio will replicate the value of the target option for a wide range of stock prices and times before expiration, without requiring further weight adjustments. We call this method static replication. It makes no assumptions beyond those of standard options theory. You can use the technique to construct static hedges for exotic options, thereby minimizing dynamic hedging risk and costs. You can use it to structure exotic payoffs from standard options. Finally, you can use it as an aid in valuing exotic options, since it lets you decompose the exotic option into a portfolio of standard options whose market prices and bid-ask spreads may be better known.

JEL Classification: G13

Suggested Citation

Derman, Emanuel and Ergener, Deniz and Kani, Iraj, Static Options Replication. JOURNAL OF DERIVATIVES, Vol 2 No 4, Available at SSRN: https://ssrn.com/abstract=6515

Emanuel Derman (Contact Author)

Columbia University ( email )

3022 Broadway
New York, NY 10027
United States
212 854 9883 (Phone)

HOME PAGE: http://www.emanuelderman.com

Deniz Ergener

Merrill Lynch ( email )

World Financial Center - North Tower
19th Floor
New York, NY 10281-1319
United States
212-670-5345 (Phone)

Iraj Kani

Samson Capital Advisors ( email )

600 Lexington Avenue, 20th Floor
New York, NY 10022
United States

Columbia University - Department of Industrial Engineering and Operations Research (IEOR) ( email )

331 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

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