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Issues in hedging options positions

Author

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  • Saikat Nandi
  • Daniel F. Waggoner

Abstract

Many financial institutions hold derivative securities in their portfolios, and frequently these securities need to be hedged for extended periods of time. Failure to hedge properly can expose an institution to sudden swings in the values of derivatives, such as options, resulting from large, unanticipated changes in the levels or volatilities of the underlying asset. Understanding the basic techniques employed for hedging derivative securities and their advantages and pitfalls is therefore of crucial importance. ; This article examines the popular valuation model for options developed by Black and Scholes (1973) and Merton (1973). The model, while elegant from a theoretical perspective, is often fraught with problems when implemented in the real world. Nevertheless, because of its simplicity and tractability, the model is widely used by options traders and investors. ; The authors consider ways that users try to circumvent some of these problems-for example, with certain ad hoc pricing rules. Using the Standard and Poor's 500 index options market, the authors compare the hedging efficacies of various models. Their findings suggest that ad hoc rules do not always result in better hedges than a very simple and internally consistent implementation of the Black-Scholes-Merton model.

Suggested Citation

  • Saikat Nandi & Daniel F. Waggoner, 2000. "Issues in hedging options positions," Economic Review, Federal Reserve Bank of Atlanta, issue Q1, pages 24-39.
  • Handle: RePEc:fip:fedaer:y:2000:i:q1:p:24-39:n:v.85no.1
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    References listed on IDEAS

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    1. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters,in: Theory Of Valuation, chapter 8, pages 229-288 World Scientific Publishing Co. Pte. Ltd..
    2. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-1632, December.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    4. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
    5. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-1252, September.
    6. Ju, Nengjiu, 1998. "Pricing an American Option by Approximating Its Early Exercise Boundary as a Multipiece Exponential Function," Review of Financial Studies, Society for Financial Studies, vol. 11(3), pages 627-646.
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    Cited by:

    1. Chris Becker & Daniel Fabbro, 2006. "Limiting Foreign Exchange Exposure through Hedging: The Australian Experience," RBA Research Discussion Papers rdp2006-09, Reserve Bank of Australia.
    2. Saikat Nandi & Daniel F. Waggoner, 2001. "The risks and rewards of selling volatility," Economic Review, Federal Reserve Bank of Atlanta, pages 31-39.

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    Keywords

    Hedging (Finance) ; Options (Finance);

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