IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this article

A Portfolio Approach to Risk Reduction in Discretely Rebalanced Option Hedges

  • Antonio S. Mello

    (School of Business, University of Wisconsin-Madison, 975 University Avenue, Madison, Wisconsin 53706-1323)

  • Henrik J. Neuhaus

    (The Nikko Securities Company, 55 Victoria Street, London SW11I 0EU, United Kingdom)

Registered author(s):

    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.

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

    File URL: http://dx.doi.org/10.1287/mnsc.44.7.921
    Download Restriction: no

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 44 (1998)
    Issue (Month): 7 (July)
    Pages: 921-934

    as
    in new window

    Handle: RePEc:inm:ormnsc:v:44:y:1998:i:7:p:921-934
    Contact details of provider: Postal:
    7240 Parkway Drive, Suite 300, Hanover, MD 21076 USA

    Phone: +1-443-757-3500
    Fax: 443-757-3515
    Web page: http://www.informs.org/
    Email:


    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.:

    as in new window
    1. 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.
    2. 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.
    3. Boyle, Phelim P. & Emanuel, David, 1980. "Discretely adjusted option hedges," Journal of Financial Economics, Elsevier, vol. 8(3), pages 259-282, September.
    4. 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.
    5. Figlewski, Stephen, 1989. " Options Arbitrage in Imperfect Markets," Journal of Finance, American Finance Association, vol. 44(5), pages 1289-1311, December.
    6. 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.
    7. 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 637-54, May-June.
    8. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
    9. Whaley, Robert E, 1986. " Valuation of American Futures Options: Theory and Empirical Tests," Journal of Finance, American Finance Association, vol. 41(1), pages 127-50, March.
    10. Hayne E. Leland., 1984. "Option Pricing and Replication with Transactions Costs," Research Program in Finance Working Papers 144, University of California at Berkeley.
    Full references (including those not matched with items on IDEAS)

    This item is not listed on Wikipedia, on a reading list or among the top 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 you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.