Robustness of Gaussian Hedges and the Hedging of Fixed Income Derivatives
AbstractThe effect of model and parameter misspecification on the effectiveness of Gaussian hedging strategies for derivative financial instrumens is analyzed, showing that Gaussian hedges in the "natural" hedging instruments are particularly robust. This is true for all models that imply Balck/Scholes - type formulas for option prices and hedging strategies. In this paper we focus on the hedging of fixed income derivatives and show how to apply these results both within the framework of Gaussian term structure models as well as the increasingly popular market models where the prices for caplets and swaptions are given by the corresponding Black formulas. By explicitly considering the behaviour of the hedging strategy under misspecification we also derive the El Karoui, Jeanblanc-Picque and Shreve (1995, 1998) and Avellaneda, Levy and Paras (1995) results that a superhedge is obtained in the Black/Scholes model if the misspecified volatility dominates the true volatility. Furthermore, we show that the robustness and superhedging result do not hold if the natural hedging instruments are unavailable. In this case, we study criteria for the optimal choice from the instruments that are available.
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Bibliographic InfoPaper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 19.
Date of creation: 01 Aug 1999
Date of revision:
Other versions of this item:
- Dudenhausen, Antje & Erik Schloegl & Lutz Schloegl, 1999. "Robustness of Gaussian Hedges and the Hedging of Fixed Income Derivatives," Discussion Paper Serie B 422, University of Bonn, Germany, revised Apr 1999.
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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