Does model misspecification matter for hedging? A computational finance experiment based approach

Youfa Sun (), George Yuan (), Shimin Guo (), Jianguo Liu () and Steven Yuan ()
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Youfa Sun: Institute of Financial Engineering, School of Management, Guangdong University of Technology, Guangzhou 510520, China
George Yuan: Institute of Risk Management, Department of Mathematics, Tongji University, Shanghai 200092, China;
Shimin Guo: School of Science, Xi'an Jiaotong University, Xi'an 710049, China
Jianguo Liu: Department of Mathematics, University of North Texas (UNT), Denton, TX76203, USA
Steven Yuan: Texas Academy of Mathematics & Science (TAMS), UNT, Denton, TX76203, USA

International Journal of Financial Engineering (IJFE), 2015, vol. 02, issue 03, 1-21

Abstract: To assess whether the model misspecification matters for hedging accuracy, we carefully select six increasingly complicated asset models, i.e., the Black–Scholes (BS) model, the Merton (M) model, the Heston (H) model, the Heston jump-diffusion (HJ) model, the double Heston (dbH) model and the double Heston jump-diffusion (dbHJ) model, and then impartially evaluate their performances in mitigating the risk of an option, under a controllable experimental market. In experiments, the ℙ measure asset paths are piecewisely simulated by a hybrid-model (including the Black–Scholes-type and the (double) Heston-type, with or without jump-diffusion term) with randomly given properly defined parameters. We access the hedging accuracy of six models within the operational dynamic hedging framework proposed by sun (2015), and apply the Fourier-COS-expansion method (i.e., the COS formula, Fang and Oosterlee (2008) to price options and to calculate the Greeks). Extensive numerical results indicate that the model misspecification shows no significant impact on hedging accuracy, but the market fit does matter critically for hedging.

Keywords: Option pricing; double Heston model; COS method; delta hedging; dynamic hedging; implied volatility surface (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S2424786315500231

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