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An Examination of the Effects of Parameter Misspecification

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  • Antje Dudenhausen
  • Lutz Schlögl
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    Abstract

    It is well-known that Gaussian hedging strategies are robust in the sense that they always lead to a cost process of bounded variation and that a superhedge is possible if upper bounds on the volatility of the relevant processes are available, cf. El Karoui, Jeanblanc-Picque and Shreve (1998) and in particular for applications to fixed income derivatives Dudenhausen, Schlögl and Schlögl (1998). These results crucially depend on the choice of certain ``natural'' hedge instruments which are not always available in the market and fail to hold otherwise. In this paper, the problem of optimally selecting hedging instruments from a given set of traded assets, in particular of zero coupon bonds, is studied. Misspecified hedging strategies lead to a non-vanishing cost process, which in turn depends on the particular choice of instruments. The effect of this choice on the cost process is analyzed. Referring to bond markets, a thorough study of the implications of volatility mismatching is made and explicit results are stated for a broad range of volatility scenarios.

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    Bibliographic Info

    Paper provided by University of Bonn, Germany in its series Bonn Econ Discussion Papers with number bgse22_2002.

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    Length: 19
    Date of creation: Sep 2002
    Date of revision:
    Handle: RePEc:bon:bonedp:bgse22_2002

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    Postal: Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany
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    Web page: http://www.bgse.uni-bonn.de

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    Keywords: Model misspecification; duplication of bonds; volatility mismatch; optimal selection of hedging instruments;

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