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Recipes for hedging exotics with illiquid vanillas

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  • Joaquin Fernandez-Tapia
  • Olivier Gu'eant

Abstract

In this paper, we address the question of the optimal Delta and Vega hedging of a book of exotic options when there are execution costs associated with the trading of vanilla options. In a framework where exotic options are priced using a market model (e.g. a local volatility model recalibrated continuously to vanilla option prices) and vanilla options prices are driven by a stochastic volatility model, we show that, using simple approximations, the optimal dynamic Delta and Vega hedging strategies can be computed easily using variational techniques.

Suggested Citation

  • Joaquin Fernandez-Tapia & Olivier Gu'eant, 2020. "Recipes for hedging exotics with illiquid vanillas," Papers 2005.10064, arXiv.org, revised May 2020.
    • Handle: RePEc:arx:papers:2005.10064
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    References listed on IDEAS

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