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Hedged Monte-Carlo: low variance derivative pricing with objective probabilities

Author

Listed:
  • Marc Potters

    (Science & Finance, Capital Fund Management)

  • Jean-Philippe Bouchaud

    (Science & Finance, Capital Fund Management
    CEA Saclay;)

  • Dragan Sestovic

Abstract

We propose a new `hedged' Monte-Carlo (HMC) method to price financial derivatives, which allows to determine simultaneously the optimal hedge. The inclusion of the optimal hedging strategy allows one to reduce the financial risk associated with option trading, and for the very same reason reduces considerably the variance of our HMC scheme as compared to previous methods. The explicit accounting of the hedging cost naturally converts the objective probability into the `risk-neutral' one. This allows a consistent use of purely historical time series to price derivatives and obtain their residual risk. The method can be used to price a large class of exotic options, including those with path dependent and early exercise features.

Suggested Citation

  • Marc Potters & Jean-Philippe Bouchaud & Dragan Sestovic, 2000. "Hedged Monte-Carlo: low variance derivative pricing with objective probabilities," Science & Finance (CFM) working paper archive 500031, Science & Finance, Capital Fund Management.
    • Handle: RePEc:sfi:sfiwpa:500031
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    References listed on IDEAS

    as
    1. Andrew Matacz & Jean-Philippe Bouchaud, 1999. "An empirical investigation of the forward interest rate term structure," Science & Finance (CFM) working paper archive 500047, Science & Finance, Capital Fund Management.
    2. Mantegna,Rosario N. & Stanley,H. Eugene, 2007. "Introduction to Econophysics," Cambridge Books, Cambridge University Press, number 9780521039871.
    3. Farhat Selmi & Jean-Philippe Bouchaud, 2000. "Hedging large risks reduces the transaction costs," Science & Finance (CFM) working paper archive 500033, Science & Finance, Capital Fund Management.
    4. Andrew Matacz & Jean-Philippe Bouchaud, 2000. "An Empirical Investigation Of The Forward Interest Rate Term Structure," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 3(04), pages 703-729.
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    Citations

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    Cited by:

    1. Lisa Borland & Jean-Philippe Bouchaud & Jean-Francois Muzy & Gilles Zumbach, 2005. "The Dynamics of Financial Markets -- Mandelbrot's multifractal cascades, and beyond," Science & Finance (CFM) working paper archive 500061, Science & Finance, Capital Fund Management.
    2. Tompkins, Robert G. & D'Ecclesia, Rita L., 2006. "Unconditional return disturbances: A non-parametric simulation approach," Journal of Banking & Finance, Elsevier, vol. 30(1), pages 287-314, January.
    3. Benoit Pochard & Jean-Philippe Bouchaud, 2003. "Option pricing and hedging with minimum expected shortfall," Science & Finance (CFM) working paper archive 500029, Science & Finance, Capital Fund Management.

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    More about this item

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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