A Portfolio Approach to Risk Reduction in Discretely Rebalanced Option Hedges
This paper analyses the accumulated hedging errors generated by discretely rebalanced option hedges. We show that simple generalizations of the prior research can underestimate the variance of the accumulated hedging errors and that even with daily rebalancing, these accumulated hedging errors can introduce substantial risk in arbitrage strategies suggested by the Black-Scholes option pricing model. We also show that the correlation between the accumulated hedging errors for different options can be quite high, so that the risk of arbitrage due to hedging errors can be substantially reduced by optimally combining options into portfolios. The results also suggest that tests of market pricing of traded options which are based on employing a portfolio approach are likely to be much better specified than the standard tests that focus on individual options.
Volume (Year): 44 (1998)
Issue (Month): 7 (July)
|Contact details of provider:|| Postal: 7240 Parkway Drive, Suite 300, Hanover, MD 21076 USA|
Web page: http://www.informs.org/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Leland, Hayne E, 1985.
" Option Pricing and Replication with Transactions Costs,"
Journal of Finance,
American Finance Association, vol. 40(5), pages 1283-1301, December.
- Hayne E. Leland., 1984. "Option Pricing and Replication with Transactions Costs," Research Program in Finance Working Papers 144, University of California at Berkeley.
- Whaley, Robert E., 1982. "Valuation of American call options on dividend-paying stocks : Empirical tests," Journal of Financial Economics, Elsevier, vol. 10(1), pages 29-58, March.
- 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..
- Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
- Boyle, Phelim P. & Emanuel, David, 1980. "Discretely adjusted option hedges," Journal of Financial Economics, Elsevier, vol. 8(3), pages 259-282, September.
- 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.
- Figlewski, Stephen, 1989. " Options Arbitrage in Imperfect Markets," Journal of Finance, American Finance Association, vol. 44(5), pages 1289-1311, December.
- Whaley, Robert E, 1986. " Valuation of American Futures Options: Theory and Empirical Tests," Journal of Finance, American Finance Association, vol. 41(1), pages 127-150, March.
- Gilster, John E., 1990. "The Systematic Risk of Discretely Rebalanced Option Hedges," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(04), pages 507-516, December.
- Wiggins, James B., 1987. "Option values under stochastic volatility: Theory and empirical estimates," Journal of Financial Economics, Elsevier, vol. 19(2), pages 351-372, December.
- Chiras, Donald P. & Manaster, Steven, 1978. "The information content of option prices and a test of market efficiency," Journal of Financial Economics, Elsevier, vol. 6(2-3), pages 213-234. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:inm:ormnsc:v:44:y:1998:i:7:p:921-934. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Mirko Janc)
If references are entirely missing, you can add them using this form.