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Static Replication and Model Risk: Razor's Edge or Trader's Hedge?

Author

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  • Morten Nalholm

    (Department of Finance, Copenhagen Business School)

  • Rolf Poulsen

    (Institute for Mathematical Sciences, University of Copenhagen)

Abstract

We investigate how sensitive a variety of dynamic and static hedge strategies for barrier options are to model risk. We find that using plain vanilla options to hedge barrier options offers considerable improvements over usual ?-hedges. Further, we show that the hedge portfolios involving options are relatively more sensitive to model risk, the Devil is in the detail, but that the degree of misspecification sensitivity is quite robust across commonly used models.

Suggested Citation

  • Morten Nalholm & Rolf Poulsen, 2005. "Static Replication and Model Risk: Razor's Edge or Trader's Hedge?," FRU Working Papers 2005/02, University of Copenhagen. Department of Economics. Finance Research Unit.
  • Handle: RePEc:kud:kuiefr:200502
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