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

  • Pascal François
  • Geneviève Gauthier
  • Frédéric Godin
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    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.

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    File URL: http://www.cirpee.org/fileadmin/documents/Cahiers_2012/CIRPEE12-34.pdf
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    Paper provided by CIRPEE in its series Cahiers de recherche with number 1234.

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    Date of creation: 2012
    Date of revision:
    Handle: RePEc:lvl:lacicr:1234
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    1. 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, 04.
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    4. Lee, Hsiang-Tai, 2009. "Optimal futures hedging under jump switching dynamics," Journal of Empirical Finance, Elsevier, vol. 16(3), pages 446-456, June.
    5. 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.
    6. 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.
    7. Hans FÃllmer & Peter Leukert, 1999. "Quantile hedging," Finance and Stochastics, Springer, vol. 3(3), pages 251-273.
    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. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
    11. Jin-Chuan Duan, 1995. "The Garch Option Pricing Model," Mathematical Finance, Wiley Blackwell, vol. 5(1), pages 13-32.
    12. Jun Sekine, 2004. "Dynamic Minimization of Worst Conditional Expectation of Shortfall," Mathematical Finance, Wiley Blackwell, vol. 14(4), pages 605-618.
    13. Ioannis Karatzas & Jaksa Cvitanic, 1999. "On dynamic measures of risk," Finance and Stochastics, Springer, vol. 3(4), pages 451-482.
    14. Jin-Chuan Duan & Ivilina Popova & Peter Ritchken, 2002. "Option pricing under regime switching," Quantitative Finance, Taylor & Francis Journals, vol. 2(2), pages 116-132.
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