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A profitable modification to global quadratic hedging

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  • Augustyniak, Maciej
  • Godin, Frédéric
  • Simard, Clarence

Abstract

Recent research has shown that global quadratic hedging, also known as variance-optimal hedging and mean-variance hedging, can significantly reduce the risk of hedging call and put options with long-term maturities (one year or more), such as Long-Term Equity AnticiPation Securities (LEAPS). We propose a modification to global quadratic hedging that is more profitable on average to the hedger without substantially increasing his downside hedging risk, if at all. We prove mathematically that the expected terminal hedging gain of our modified strategy is greater than that of the global quadratic hedging strategy. The performance of our strategy is evaluated under simulated return paths from GARCH, regime-switching and jump-diffusion models, and under empirical S&P 500 return paths.

Suggested Citation

  • Augustyniak, Maciej & Godin, Frédéric & Simard, Clarence, 2019. "A profitable modification to global quadratic hedging," Journal of Economic Dynamics and Control, Elsevier, vol. 104(C), pages 111-131.
    • Handle: RePEc:eee:dyncon:v:104:y:2019:i:c:p:111-131
    DOI: 10.1016/j.jedc.2019.05.008
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    References listed on IDEAS

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    1. Martin Schweizer, 1995. "Variance-Optimal Hedging in Discrete Time," Mathematics of Operations Research, INFORMS, vol. 20(1), pages 1-32, February.
    2. 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.
    3. Ales Cerny, 2004. "Dynamic programming and mean-variance hedging in discrete time," Applied Mathematical Finance, Taylor & Francis Journals, vol. 11(1), pages 1-25.
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    11. Christoffersen, Peter & Dorion, Christian & Jacobs, Kris & Wang, Yintian, 2010. "Volatility Components, Affine Restrictions, and Nonnormal Innovations," Journal of Business & Economic Statistics, American Statistical Association, vol. 28(4), pages 483-502.
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    More about this item

    Keywords

    Risk management; Variance-optimal hedging; Mean-variance hedging; Global risk-minimization; LEAPS;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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