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Optimal Hedging when the Underlying Asset Follows a Regime-switching Markov Process

Author

Listed:
  • Pascal François
  • Geneviève Gauthier
  • Frédéric Godin

Abstract

We develop a flexible discrete-time hedging methodology that minimizes the expected value of any desired penalty function of the hedging error within a general regime-switching framework. A numerical algorithm based on backward recursion allows for the sequential construction of an optimal hedging strategy. Numerical experiments comparing this and other methodologies show a relative expected penalty reduction ranging between 0.9% and 12.6% with respect to the best benchmark.

Suggested Citation

  • Pascal François & Geneviève Gauthier & Frédéric Godin, 2012. "Optimal Hedging when the Underlying Asset Follows a Regime-switching Markov Process," Cahiers de recherche 1234, CIRPEE.
  • Handle: RePEc:lvl:lacicr:1234
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    File URL: http://www.cirpee.org/fileadmin/documents/Cahiers_2012/CIRPEE12-34.pdf
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    References listed on IDEAS

    as
    1. Robert J. Elliott & Leunglung Chan & Tak Kuen Siu, 2005. "Option pricing and Esscher transform under regime switching," Annals of Finance, Springer, vol. 1(4), pages 423-432, October.
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    7. Lee, Hsiang-Tai, 2009. "Optimal futures hedging under jump switching dynamics," Journal of Empirical Finance, Elsevier, vol. 16(3), pages 446-456, June.
    8. Schweizer, Martin, 1991. "Option hedging for semimartingales," Stochastic Processes and their Applications, Elsevier, vol. 37(2), pages 339-363, April.
    9. Mingxin Xu, 2006. "Risk measure pricing and hedging in incomplete markets," Annals of Finance, Springer, vol. 2(1), pages 51-71, January.
    10. Alizadeh, Amir H. & Nomikos, Nikos K. & Pouliasis, Panos K., 2008. "A Markov regime switching approach for hedging energy commodities," Journal of Banking & Finance, Elsevier, vol. 32(9), pages 1970-1983, September.
    11. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
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    13. Donald Lien, 2012. "A note on the performance of regime switching hedge strategy," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 32(4), pages 389-396, April.
    14. Hans FÃllmer & Peter Leukert, 1999. "Quantile hedging," Finance and Stochastics, Springer, vol. 3(3), pages 251-273.
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    More about this item

    Keywords

    Dynamic programming; hedging; risk management; regime switching;

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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