Model Uncertainty, Recalibration, and the Emergence of Delta-Vega Hedging

Sebastian Herrmann and Johannes Muhle-Karbe
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Sebastian Herrmann: ETH Zurich
Johannes Muhle-Karbe: ETH Zurich and Swiss Finance Institute

No 15-52, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We study option pricing and hedging with uncertainty about a Black-Scholes reference model which is dynamically recalibrated to the market price of a liquidly traded vanilla option. For dynamic trading in the underlying asset and this vanilla option, delta-vega hedging is asymptotically optimal in the limit for small uncertainty aversion. The corresponding indifference price corrections are determined by the disparity between the vegas, gammas, vannas, and volgas of the non-traded and the liquidly traded options.

Keywords: model uncertainty; recalibration; delta-vega hedging; small uncertainty aversion; asymptotics (search for similar items in EconPapers)
JEL-codes: C61 C73 G13 (search for similar items in EconPapers)
Pages: 43 pages
Date: 2015-11, Revised 2016-07
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1552

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