The relative efficiency of option hedging strategies using the third-order stochastic dominance

Margareta Gardijan Kedžo () and Boško Šego ()
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Margareta Gardijan Kedžo: University of Zagreb
Boško Šego: University of Zagreb

Computational Management Science, 2021, vol. 18, issue 4, No 3, 477-504

Abstract: Abstract The selection of an appropriate portfolio hedging strategy is a concern for both investment theory and practice. Options are believed to be flexible and useful hedging instruments, but they are also complicated to manage and costly to implement in a strategy, intensifying the financial leverage, and thus increasing the riskiness of a portfolio. This paper investigates the hedging strategies with options as efficient hedging tools and the possibility to identify an efficient hedging strategy with options that will not result in smaller utility for investors, compared to other strategies under defined criteria. The empirical analysis is based on simulated returns of the following trading strategies: a covered call, protective put, collar, ratio covered call strategy and a buy-and-hold unhedged stock. The return distributions of these strategies are compared using the stochastic dominance criteria up to the third degree, which is an appropriate approach for investors who prefer the greater return, are risk-averse in terms of downside volatility and in terms of a loss, and who prefer greater positive skewness. The results obtained from the simulated returns indicate that portfolio hedging strategies with options are never dominated by an unhedged portfolio. This finding confirms that hedging strategies with options are useful tools for risk hedging. The methodology used in the paper also presents the general framework that can be used in investment decision-making in the presence of uncertainty.

Keywords: Hedging; Risk management; Options; Stochastic dominance; Portfolio choice (search for similar items in EconPapers)
JEL-codes: C61 D81 G11 (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (1)

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DOI: 10.1007/s10287-021-00401-z

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