Hedging The Risk In The Continuous Time Option Pricing Model With Stochastic Stock Volatility

D. F. Wang
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D. F. Wang: TD Bank and Univ. of Waterloo

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Abstract: In this work, I address the issue of forming riskless hedge in the continuous time option pricing model with stochastic stock volatility. I show that it is essential to verify whether the replicating portfolio is self-financing, in order for the theory to be self-consistent. The replicating methods in existing finance literature are shown to violate the self-financing constraint when the underlying asset has stochastic volatility. Correct self-financing hedge is formed in this article.

Date: 1998-07
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