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Simple Robust Hedging with Nearby Contracts

Author

Listed:
  • Liuren Wu
  • Jingyi Zhu

Abstract

This paper proposes a new hedging strategy based on approximate matching of contract characteristics instead of risk sensitivities. The strategy hedges an option with three options at different maturities and strikes by matching the option function expansion along maturity and strike rather than risk factors. Its hedging effectiveness varies with the maturity and strike distance between the target and the hedge options, but is robust to variations in the underlying risk dynamics. Simulation analysis under different risk environments and historical analysis on S&P 500 index options both show that a wide spectrum of strike-maturity combinations can outperform dynamic delta hedging.

Suggested Citation

  • Liuren Wu & Jingyi Zhu, 2017. "Simple Robust Hedging with Nearby Contracts," Journal of Financial Econometrics, Oxford University Press, vol. 15(1), pages 1-35.
    • Handle: RePEc:oup:jfinec:v:15:y:2017:i:1:p:1-35.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbw007
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    References listed on IDEAS

    as
    1. David C. Nachman, 1988. "Spanning and Completeness with Options," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 311-328.
    2. C. He & J. Kennedy & T. Coleman & P. Forsyth & Y. Li & K. Vetzal, 2006. "Calibration and hedging under jump diffusion," Review of Derivatives Research, Springer, vol. 9(1), pages 1-35, January.
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    More about this item

    Keywords

    characteristics matching; hedging; jumps; Monte Carlo; payoff matching; risk sensitivity matching; strike-maturity triangle; stochastic volatility; S&P 500 index options; Taylor expansion;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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