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Hedging diffusion processes by local risk minimization with applications to index tracking

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  • Colwell, David
  • El-Hassan, Nadima
  • Kang Kwon, Oh

Abstract

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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Suggested Citation

  • Colwell, David & El-Hassan, Nadima & Kang Kwon, Oh, 2007. "Hedging diffusion processes by local risk minimization with applications to index tracking," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2135-2151, July.
  • Handle: RePEc:eee:dyncon:v:31:y:2007:i:7:p:2135-2151
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    References listed on IDEAS

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    1. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    2. Schweizer, Martin, 1991. "Option hedging for semimartingales," Stochastic Processes and their Applications, Elsevier, vol. 37(2), pages 339-363, April.
    3. 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.
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    Cited by:

    1. Liang-chuan Wu & I-chan Tsai, 2014. "Three fuzzy goal programming models for index portfolios," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 65(8), pages 1155-1169, August.
    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.
    3. 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.

    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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