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Should Market Makers Hedge with Realised or Implied Volatility?

In: Advances in Longitudinal Data Methods in Applied Economic Research

Author

Listed:
  • Alexis Levendis

    (University of Johannesburg
    University of Pretoria)

  • Pierre Venter

    (University of Johannesburg
    University of Pretoria)

  • Eben Maré

    (University of Pretoria)

Abstract

A major challenge faced by market makers is the hedging of contingent liabilities. Option sellers often hedge contingent claims in the classical Black–Scholes framework. Standard theory suggests that the value of an option can be replicated exactly by rebalancing a portfolio of shares and cash continuously. This is referred to as delta-hedging. In the Black–Scholes framework, an explicit solution is available to calculate delta. Market participants agree on most inputs in this formula. Volatility, however, remains an elusive parameter. This leads to the question: Should market makers hedge their liabilities using realised or implied volatility? In this paper, we show that a market maker should choose to hedge their portfolio with implied volatility, since this is less risky than hedging with realised volatility.

Suggested Citation

  • Alexis Levendis & Pierre Venter & Eben Maré, 2021. "Should Market Makers Hedge with Realised or Implied Volatility?," Springer Proceedings in Business and Economics, in: Nicholas Tsounis & Aspasia Vlachvei (ed.), Advances in Longitudinal Data Methods in Applied Economic Research, pages 421-430, Springer.
    • Handle: RePEc:spr:prbchp:978-3-030-63970-9_29
    DOI: 10.1007/978-3-030-63970-9_29
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