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

Morten Nalholm and Rolf Poulsen
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Morten Nalholm: Department of Finance, Copenhagen Business School
Rolf Poulsen: Institute for Mathematical Sciences, University of Copenhagen

No 2005/02, FRU Working Papers from University of Copenhagen. Department of Economics. Finance Research Unit

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.

Pages: 19 pages
Date: 2005-03
New Economics Papers: this item is included in nep-fmk and nep-rmg
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