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Model Uncertainty, Recalibration, and the Emergence of Delta-Vega Hedging

Author

Listed:
  • Sebastian Herrmann

    (ETH Zurich)

  • Johannes Muhle-Karbe

    (ETH Zurich and Swiss Finance Institute)

Abstract

We study option pricing and hedging with uncertainty about a Black-Scholes reference model which is dynamically recalibrated to the market price of a liquidly traded vanilla option. For dynamic trading in the underlying asset and this vanilla option, delta-vega hedging is asymptotically optimal in the limit for small uncertainty aversion. The corresponding indifference price corrections are determined by the disparity between the vegas, gammas, vannas, and volgas of the non-traded and the liquidly traded options.

Suggested Citation

  • Sebastian Herrmann & Johannes Muhle-Karbe, 2015. "Model Uncertainty, Recalibration, and the Emergence of Delta-Vega Hedging," Swiss Finance Institute Research Paper Series 15-52, Swiss Finance Institute, revised Jul 2016.
    • Handle: RePEc:chf:rpseri:rp1552
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    File URL: http://ssrn.com/abstract=2694718
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    Cited by:

    1. Johannes Muhle-Karbe & Marcel Nutz, 2016. "A Risk-Neutral Equilibrium Leading to Uncertain Volatility Pricing," Papers 1612.09152, arXiv.org, revised Jan 2018.

    More about this item

    Keywords

    model uncertainty; recalibration; delta-vega hedging; small uncertainty aversion; asymptotics;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games

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