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A Note on Hedging in ARCH and Stochastic Volatility Option Pricing Models

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  • René Garcia
  • Èric Renault

Abstract

Recently, Duan (1995) proposed a GARCH option pricing formula and a corresponding hedging formula. In a similar ARCH‐type model for the underlying asset, Kallsen and Taqqu (1994) arrived at a hedging formula different from Duan's although they concur on the pricing formula. In this note, we explain this difference by pointing out that the formula developed by Kallsen and Taqqu corresponds to the usual concept of hedging in the context of ARCH‐type models. We argue, however, that Duan's formula has some appeal and we propose a stochastic volatility model that ensures its validity. We conclude by a comparison of ARCH‐type and stochastic volatility option pricing models.

Suggested Citation

  • René Garcia & Èric Renault, 1998. "A Note on Hedging in ARCH and Stochastic Volatility Option Pricing Models," Mathematical Finance, Wiley Blackwell, vol. 8(2), pages 153-161, April.
    • Handle: RePEc:bla:mathfi:v:8:y:1998:i:2:p:153-161
    DOI: 10.1111/1467-9965.00049
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    1. Marcel Boyer, 1997. "Competition and Access in Telecoms: ECPR, Global Price Cap, and Auctions," CIRANO Working Papers 97s-03, CIRANO.
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    Cited by:

    1. Peter Christoffersen & Kris Jacobs, 2002. "Which Volatility Model for Option Valuation?," CIRANO Working Papers 2002s-33, CIRANO.
    2. Jean Pierre Fernández Prada Saucedo & Gabriel Rodríguez, 2020. "Modeling the Volatility of Returns on Commodities: An Application and Empirical Comparison of GARCH and SV Models," Documentos de Trabajo / Working Papers 2020-484, Departamento de Economía - Pontificia Universidad Católica del Perú.
    3. Peter Christoffersen & Kris Jacobs, 2004. "Which GARCH Model for Option Valuation?," Management Science, INFORMS, vol. 50(9), pages 1204-1221, September.
    4. Matthias R. Fengler & Helmut Herwartz & Christian Werner, 2012. "A Dynamic Copula Approach to Recovering the Index Implied Volatility Skew," Journal of Financial Econometrics, Oxford University Press, vol. 10(3), pages 457-493, June.
    5. Bauwens, Luc & Lubrano, Michel, 2002. "Bayesian option pricing using asymmetric GARCH models," Journal of Empirical Finance, Elsevier, vol. 9(3), pages 321-342, August.
    6. Maciej Augustyniak & Frédéric Godin & Clarence Simard, 2017. "Assessing the effectiveness of local and global quadratic hedging under GARCH models," Quantitative Finance, Taylor & Francis Journals, vol. 17(9), pages 1305-1318, September.
    7. Garcia, R. & Renault, E., 1998. "Risk Aversion, Intertemporal Substitution, and Option Pricing," Cahiers de recherche 9801, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
    8. Bruno R'emillard & Sylvain Rubenthaler, 2012. "Optimal hedging in discrete time," Papers 1211.5035, arXiv.org.
    9. Fengler, Matthias R. & Hin, Lin-Yee, 2015. "Semi-nonparametric estimation of the call-option price surface under strike and time-to-expiry no-arbitrage constraints," Journal of Econometrics, Elsevier, vol. 184(2), pages 242-261.
    10. Jin-Chuan Duan & Peter H. Ritchken & Zhiqiang Sun, 2006. "Jump starting GARCH: pricing and hedging options with jumps in returns and volatilities," Working Papers (Old Series) 0619, Federal Reserve Bank of Cleveland.
    11. Maciej Augustyniak & Alexandru Badescu, 2021. "On the computation of hedging strategies in affine GARCH models," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(5), pages 710-735, May.

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    • G1 - Financial Economics - - General Financial Markets

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