Delta Hedging Under Estimation Risk

15 Pages Posted: 17 May 2007

See all articles by George Dotsis

George Dotsis

National Kapodistrian University of Athens - Faculty of Economics; Essex Finance Centre, Essex Business School, University of Essex

Date Written: 2007

Abstract

This paper examines the hedging errors resulting from the use of mis-estimated volatilities. To this end, the hedging errors of European options are studied via closed form solutions. It is shown that the hedging errors depend on the level of moneyness of the option and the realised drift and volatility of the actual path followed by the underlying asset. Furthermore, it is also shown that if the option is sold at a larger volatility but hedged at a different volatility robust hedging does not hold and the trade may result in a loss. The results are verified using S&P 500 stock index data.

Keywords: Hedging errors, estimation risk, volatility mis-estimation,realised drift

JEL Classification: G11, G12, G13

Suggested Citation

Dotsis, George, Delta Hedging Under Estimation Risk (2007). Available at SSRN: https://ssrn.com/abstract=987038 or http://dx.doi.org/10.2139/ssrn.987038

George Dotsis (Contact Author)

National Kapodistrian University of Athens - Faculty of Economics ( email )

Greece

HOME PAGE: http://sites.google.com/site/gdotsis/

Essex Finance Centre, Essex Business School, University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

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