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Hedging Diffusion Processes by Local Risk-Minimisation with Applications to Index Tracking

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The solution to the problem of hedging contingent claims by local risk-minimisation has been considered in detail in Follmer and Sondermann (1986), Follmer and Schweizer (1991) and Schweizer (1991). However, given a stochastic process Xt and tau1 tau2, the strategy that is locally risk-minimising for Xtau1 is in general not locally risk-minimising for Xtau2. In the case of diffusion processes, this paper considers the problem of determining a strategy that is simultaneously locally risk-minimising for Xtau for all tau. That is, a strategy that is locally risk-minimising for the entire process Xt. The necessary and sufficient conditions under which this is possible are obtained, and applied to the problem of index tracking. In particular, a close connection between the local risk-minimising and the tracking error variance minimising strategies for index tracking is established, and leads to a simple criterion for the selection of optimal set of assets from which to form a tracker portfolio, as well as a value-at-risk type measure for the set of assets used.

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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 119.

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Date of creation: 01 Feb 2004
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Handle: RePEc:uts:rpaper:119

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Keywords: minimal martingale measure; local risk-minimisation; hedging; incomplete market; index tracking; portfolio selection;

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  1. Martin Schweizer & HuyËn Pham & (*), Thorsten RheinlÄnder, 1998. "Mean-variance hedging for continuous processes: New proofs and examples," Finance and Stochastics, Springer, vol. 2(2), pages 173-198.
  2. Schweizer, Martin, 1991. "Option hedging for semimartingales," Stochastic Processes and their Applications, Elsevier, vol. 37(2), pages 339-363, April.
  3. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
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Cited by:
  1. Canakgoz, N.A. & Beasley, J.E., 2009. "Mixed-integer programming approaches for index tracking and enhanced indexation," European Journal of Operational Research, Elsevier, vol. 196(1), pages 384-399, July.
  2. Frey, Rüdiger & Backhaus, Jochen, 2010. "Dynamic hedging of synthetic CDO tranches with spread risk and default contagion," Journal of Economic Dynamics and Control, Elsevier, vol. 34(4), pages 710-724, April.

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