(S,s)-adjustment Strategies and Hedging under Markovian Dynamics

Elettra Agliardi and Rainer Andergassen

The Geneva Risk and Insurance Review, 2011, vol. 36, issue 2, 112-131

Abstract: We study the destabilizing effect of hedging strategies under Markovian dynamics with transaction costs. Once transaction costs are taken into account, continuous portfolio rehedging is no longer an optimal strategy. Using a non-optimizing (local in time) strategy for portfolio rebalancing, explicit dynamics for the price of the underlying asset are derived, focusing in particular on excess volatility and feedback effects of these portfolio insurance strategies. Moreover, it is shown how these latter depend on the heterogeneity of the insured payoffs. Finally, conditions are derived under which it may be still reasonable, from a practical viewpoint, to implement Black–Scholes strategies.

Date: 2011
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