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Adapted hedging

Author

Listed:
  • Dilip B. Madan

    (University of Maryland)

Abstract

Exponentials of squared returns in Gaussian densities, with their consequently thin tails, are replaced by the absolute return to form Laplacian and exponentially tilted Laplacian densities at unit time. Scaling provides densities at other maturities. Stochastic processes with these marginals are identified. In addition to a specific local volatility model the densities are consistent with the difference of compound exponential processes taken at log time and scaled by the square root of time. The underlying process has a single parameter, the constant variance rate of the process. Delta hedging using Laplacian and Asymmetric Laplacian implied volatilities are developed and compared with Black Merton Scholes implied volatility hedging.The hedging strategies are implemented for stylized businesses represented by dynamic volatility indexes. The Laplacian hedge is seen to be smoother for the skew trade. It also performs better through the financial crisis for the sale of strangles. The Laplacian and Gaussian models are then synthesized as special cases of a model allowing for other powers between unity and the square. Numerous hedging strategies may be run using different powers and biases in the probability of an up move. Adapted strategies that select the best performer on past quarterly data can dominate fixed strategies. Adapted hedging strategies can effectively reduce drawdowns in the marked to market value of businesses trading options.

Suggested Citation

  • Dilip B. Madan, 2016. "Adapted hedging," Annals of Finance, Springer, vol. 12(3), pages 305-334, December.
    • Handle: RePEc:kap:annfin:v:12:y:2016:i:3:d:10.1007_s10436-016-0282-8
    DOI: 10.1007/s10436-016-0282-8
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    References listed on IDEAS

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    Cited by:

    1. Kathrin Glau & Paul Herold & Dilip B. Madan & Christian Potz, 2017. "The Chebyshev method for the implied volatility," Papers 1710.01797, arXiv.org.
    2. Madan, Dilip B. & Smith, Robert H. & Wang, King, 2017. "Laplacian risk management," Finance Research Letters, Elsevier, vol. 22(C), pages 202-210.

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    More about this item

    Keywords

    Fat tails; Bid prices; Non-additive probability; Dynamic volatility indices;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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