Delta Hedging Under Estimation Risk
15 Pages Posted: 17 May 2007
Date Written: 2007
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
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