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Hedging Large Portfolios of Options in Discrete Time

Listed author(s):
  • B. Peeters
  • C. L. Dert
  • A. Lucas

The problem studied is that of hedging a portfolio of options in discrete time where underlying security prices are driven by a combination of idiosyncratic and systematic risk factors. It is shown that despite the market incompleteness introduced by the discrete time assumption, large portfolios of options have a unique price and can be hedged without risk. The nature of the hedge portfolio in the limit of large portfolio size is substantially different from its continuous time counterpart. Instead of linearly hedging the total risk of each option separately, the correct portfolio hedge in discrete time eliminates linear as well as second and higher order exposures to the systematic risk factors only. The idiosyncratic risks need not be hedged, but disappear through diversification. Hedging portfolios of options in discrete time thus entails a trade-off between dynamic and cross-sectional hedging errors. Some computations are provided on the outcome of this trade-off in a discrete-time Black-Scholes world.

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Article provided by Taylor & Francis Journals in its journal Applied Mathematical Finance.

Volume (Year): 15 (2008)
Issue (Month): 3 ()
Pages: 251-275

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Handle: RePEc:taf:apmtfi:v:15:y:2008:i:3:p:251-275
DOI: 10.1080/13504860701718471
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