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Stochastic Volatility: Risk Minimization and Model Risk


  • Christian-Olivier Ewald

    (School of Mathematics, University of Leeds)

  • Rolf Poulsen

    (Department of Mathematical Sciences, University of Copenhagen)

  • Klaus Reiner Schenk-Hoppe

    (School of Mathematics and Leeds University Business School, University of Leeds)


In this paper locally risk-minimizing hedge strategies for European-style contingent claims are derived and tested for a general class of stochastic volatility models. These strategies are as easy to implement as ordinary delta hedges, yet in realistic settings they produce markedly lower hedge errors. Our experimental investigations on model risk furthermore show that locally risk-minimizing hedges are robust with respect to parameter uncertainty as well as misspecifications of the stochastic volatility model.

Suggested Citation

  • Christian-Olivier Ewald & Rolf Poulsen & Klaus Reiner Schenk-Hoppe, 2007. "Stochastic Volatility: Risk Minimization and Model Risk," Swiss Finance Institute Research Paper Series 07-10, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp0710

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    Locally risk-minimizing hedge; delta hedge; stochastic volatility; model risk;

    JEL classification:

    • C90 - Mathematical and Quantitative Methods - - Design of Experiments - - - General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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