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Model Risk Analysis for Entropic Hedging Strategies

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  • Paul McCloud

Abstract

Market incompleteness causes residual profit and loss after hedging that is accounted for with valuation adjustments and bid-offer spreads acting as model risk buffers for the derivative price. Entropic risk optimisation is a general framework for modelling these adjustments. When the prices are quadratic Gaussian, the coupled equations for price and hedge ratios are solved exactly, with a decomposition of the entropic risk into convexity, dimensionality, funding and strategy contributions that are attributed in the explanation of realised P&L. The results are applicable when the underlying prices follow Gaussian processes, such as fractional Ornstein-Uhlenbeck processes. The article concludes with analysis of the continuous hedging limit for these processes, and a discussion of their application in data-driven regressions.

Suggested Citation

  • Paul McCloud, 2026. "Model Risk Analysis for Entropic Hedging Strategies," Papers 2610.06168, arXiv.org, revised Nov 2026.
    • Handle: RePEc:arx:papers:2610.06168
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    File URL: https://arxiv.org/pdf/2610.06168
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