MAXIMUM DRAWDOWN INSURANCE

Peter Carr, Hongzhong Zhang () and Olympia Hadjiliadis ()
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Hongzhong Zhang: Department of Statistics, Columbia University, 1255 Amsterdam Avenue, New York, New York 10027, USA
Olympia Hadjiliadis: Department of Mathematics, Brooklyn College and the Graduate Center, CUNY, New York, New York 10016, USA

International Journal of Theoretical and Applied Finance (IJTAF), 2011, vol. 14, issue 08, 1195-1230

Abstract: The drawdown of an asset is a risk measure defined in terms of the running maximum of the asset's spot price over some period [0, T]. The asset price is said to have drawn down by at least $K over this period if there exists a time at which the underlying is at least $K below its maximum-to-date. We introduce insurance against a large realization of maximum drawdown and a novel way to hedge the liability incurred by underwriting this insurance. Our proposed insurance pays a fixed amount should the maximum drawdown exceed some fixed threshold over a specified period. The need for this drawdown insurance would diminish should markets rise before they fall. Consequently, we propose a second kind of cheaper maximum drawdown insurance that pays a fixed amount contingent on the drawdown preceding a drawup. We propose double barrier options as hedges for both kinds of insurance against large maximum drawdowns. In fact for the second kind of insurance we show that the hedge is model-free. Since double barrier options do not trade liquidly in all markets, we examine the assumptions under which alternative hedges using either single barrier options or standard vanilla options can be used.

Keywords: Drawdown; drawup; static replication (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (25)

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DOI: 10.1142/S0219024911006826

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