Adapted hedging

Dilip B. Madan ()
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Dilip B. Madan: University of Maryland

Annals of Finance, 2016, vol. 12, issue 3, No 2, 305-334

Abstract: Abstract Exponentials of squared returns in Gaussian densities, with their consequently thin tails, are replaced by the absolute return to form Laplacian and exponentially tilted Laplacian densities at unit time. Scaling provides densities at other maturities. Stochastic processes with these marginals are identified. In addition to a specific local volatility model the densities are consistent with the difference of compound exponential processes taken at log time and scaled by the square root of time. The underlying process has a single parameter, the constant variance rate of the process. Delta hedging using Laplacian and Asymmetric Laplacian implied volatilities are developed and compared with Black Merton Scholes implied volatility hedging.The hedging strategies are implemented for stylized businesses represented by dynamic volatility indexes. The Laplacian hedge is seen to be smoother for the skew trade. It also performs better through the financial crisis for the sale of strangles. The Laplacian and Gaussian models are then synthesized as special cases of a model allowing for other powers between unity and the square. Numerous hedging strategies may be run using different powers and biases in the probability of an up move. Adapted strategies that select the best performer on past quarterly data can dominate fixed strategies. Adapted hedging strategies can effectively reduce drawdowns in the marked to market value of businesses trading options.

Keywords: Fat tails; Bid prices; Non-additive probability; Dynamic volatility indices (search for similar items in EconPapers)
JEL-codes: G01 G10 G13 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s10436-016-0282-8

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