Static Replication and Model Risk: Razor's Edge or Trader's Hedge?

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Static Replication and Model Risk: Razor's Edge or Trader's Hedge?

Author Info

Morten Nalholm (Department of Finance, Copenhagen Business School)
Rolf Poulsen (Institute for Mathematical Sciences, University of Copenhagen)

Abstract

We investigate how sensitive a variety of dynamic and static hedge strategies for barrier options are to model risk. We find that using plain vanilla options to hedge barrier options offers considerable improvements over usual ?-hedges. Further, we show that the hedge portfolios involving options are relatively more sensitive to model risk, the Devil is in the detail, but that the degree of misspecification sensitivity is quite robust across commonly used models.

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Paper provided by University of Copenhagen. Department of Economics. Finance Research Unit in its series FRU Working Papers with number 2005/02.

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Length: 19 pages
Date of creation: Mar 2005
Date of revision:
Handle: RePEc:kud:kuiefr:200502

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This paper has been announced in the following NEP Reports:

NEP-ALL-2005-04-03 (All new papers)
NEP-FMK-2005-04-03 (Financial Markets)
NEP-RMG-2005-04-03 (Risk Management)

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Peter Carr & Katrina Ellis & Vishal Gupta, 1998. "Static Hedging of Exotic Options," Journal of Finance, American Finance Association, vol. 53(3), pages 1165-1190, 06. [Downloadable!] (restricted)
Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring. [Downloadable!] (restricted)
Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144. [Downloadable!] (restricted)
Other versions:
- Merton, Robert C., 1975. "Option pricing when underlying stock returns are discontinuous," Working papers 787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 6(2), pages 327-43. [Downloadable!] (restricted)

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