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Hedging error as generalized timing risk

Author

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  • J. Akahori
  • F. Barsotti
  • Y. Imamura

Abstract

This paper introduces a methodology to disentangle the hedging error associated with the hedging of exotic derivatives, whose payment time is unknown at inception. We derive the mathematical representation for a one-dimensional setting: we identify and characterize the hedging error and discuss the economic intuition of hedging error as a generalized timing risk. We then provide its mathematical integral representation to: (i) disentangle the hedging error into a specific set of positions in barrier options, (ii) re-iterate the procedure to the second order to reduce the hedging error cost. We provide an illustrative example via a dedicated numerical study. From a theoretical point of view, this paper states the foundations for future extensions in the directions of: (i) building a general multidimensional framework, (ii) re-iterating the procedure to higher orders, (iii) investigate the bridge with advanced analytics methodologies and techniques.

Suggested Citation

  • J. Akahori & F. Barsotti & Y. Imamura, 2023. "Hedging error as generalized timing risk," Quantitative Finance, Taylor & Francis Journals, vol. 23(4), pages 693-703, April.
    • Handle: RePEc:taf:quantf:v:23:y:2023:i:4:p:693-703
    DOI: 10.1080/14697688.2022.2154255
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