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Static Hedging of Standard Options

Author

Listed:
  • Peter Carr
  • Liuren Wu

Abstract

Working in a single-factor Markovian setting, this article derives a new, static spanning relation between a given option and a continuum of shorter-term options written on the same asset. Compared to dynamic delta hedge, which breaks down in the presence of large random jumps, the static hedge works well under both continuous and discontinuous price dynamics. Simulation exercises show that under purely continuous price dynamics, discretized static hedges with as few as three to five options perform similarly to the dynamic delta hedge with the underlying futures and daily updating, but the static hedges strongly outperform the daily delta hedge when the underlying price process contains random jumps. A historical analysis using over 13 years of data on S&P 500 index options further validates the superior performance of the static hedging strategy in practical situations.

Suggested Citation

  • Peter Carr & Liuren Wu, 2014. "Static Hedging of Standard Options," Journal of Financial Econometrics, Oxford University Press, vol. 12(1), pages 3-46.
    • Handle: RePEc:oup:jfinec:v:12:y:2014:i:1:p:3-46.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbs014
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    More about this item

    Keywords

    Static hedging; jumps; option pricing; Monte Carlo; S&P 500 index options; stochastic volatility;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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