Hedging Options with Scale-Invariant Models

Carol Alexander and Leonardo Nogueira ()
Additional contact information
Leonardo Nogueira: ICMA Centre, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: A price process is scale-invariant if and only if the returns distribution is independent of the price level. We show that scale invariance preserves the homogeneity of a pay-off function throughout the life of the claim and hence prove that standard price hedge ratios for a wide class of contingent claims are model-free. Since options on traded assets are normally priced using some form of scale-invariant process, e.g. a stochastic volatility, jump diffusion or Lévy process, this result has important implications for the hedging literature. However, standard price hedge ratios are not always the optimal hedge ratios to use in a delta or delta-gamma hedge strategy; in fact we recommend the use of minimum variance hedge ratios for scale-invariant models. Our theoretical results are supported by an empirical study that compares the hedging performance of various smile-consistent scale-invariant and non-scale-invariant models. We find no significant difference between the minimum variance hedges in the smile-consistent models but a significant improvement upon the standard, model-free hedge ratios

Keywords: Scale invariance; hedging; minimum variance; hedging; stochastic volatility (search for similar items in EconPapers)
JEL-codes: C14 G13 (search for similar items in EconPapers)
Pages: 33 Pages
Date: 2006-06
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Forthcoming in Journal of Banking and Finance

Downloads: (external link)
http://www.icmacentre.ac.uk/pdf/discussion/DP2006-03.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found (http://www.icmacentre.ac.uk/pdf/discussion/DP2006-03.pdf [302 Found]--> https://www.icmacentre.ac.uk/pdf/discussion/DP2006-03.pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:rdg:icmadp:icma-dp2006-03

Access Statistics for this paper

More papers in ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading Contact information at EDIRC.
Bibliographic data for series maintained by Marie Pearson ().