Risk minimization in stochastic volatility models: model risk and empirical performance

Rolf Poulsen, Klaus Schenk-Hoppé and Christian-Oliver Ewald

Quantitative Finance, 2009, vol. 9, issue 6, 693-704

Abstract: In this paper the performance of locally risk-minimizing delta hedge strategies for European options in stochastic volatility models is studied from an experimental as well as from an empirical perspective. These hedge strategies are derived for a large class of diffusion-type stochastic volatility models, and they are as easy to implement as usual delta hedges. Our simulation results on model risk show that these risk-minimizing hedges are robust with respect to uncertainty and misconceptions about the underlying data generating process. The empirical study, which includes the US sub-prime crisis period, documents that in equity markets risk-minimizing delta hedges consistently outperform usual delta hedges by approximately halving the standard deviation of the profit-and-loss ratio.

Keywords: Locally risk-minimizing delta hedge; Stochastic volatility; Model risk; Empirical hedge performance (search for similar items in EconPapers)
Date: 2009
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Citations: View citations in EconPapers (31)

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DOI: 10.1080/14697680902852738

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