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Optimal Hedging when the Underlying Asset Follows a Regime-switching Markov Process

Author

Listed:
  • Pascal François
  • Geneviève Gauthier
  • Frédéric Godin

Abstract

We develop a flexible discrete-time hedging methodology that minimizes the expected value of any desired penalty function of the hedging error within a general regime-switching framework. A numerical algorithm based on backward recursion allows for the sequential construction of an optimal hedging strategy. Numerical experiments comparing this and other methodologies show a relative expected penalty reduction ranging between 0.9% and 12.6% with respect to the best benchmark.

Suggested Citation

  • Pascal François & Geneviève Gauthier & Frédéric Godin, 2012. "Optimal Hedging when the Underlying Asset Follows a Regime-switching Markov Process," Cahiers de recherche 1234, CIRPEE.
    • Handle: RePEc:lvl:lacicr:1234
    as

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    File URL: http://www.cirpee.org/fileadmin/documents/Cahiers_2012/CIRPEE12-34.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Dynamic programming; hedging; risk management; regime switching;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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