HEDGING UNDER GAMMA CONSTRAINTS BY OPTIMAL STOPPING AND FACE‐LIFTING

H. Mete Soner and Nizar Touzi

Mathematical Finance, 2007, vol. 17, issue 1, 59-79

Abstract: A super‐replication problem with a gamma constraint, introduced in Soner and Touzi, is studied in the context of the one‐dimensional Black and Scholes model. Several representations of the minimal super‐hedging cost are obtained using the characterization derived in Cheridito, Soner, and Touzi. It is shown that the upper bound constraint on the gamma implies that the optimal strategy consists in hedging a conveniently face‐lifted payoff function. Further an unusual connection between an optimal stopping problem and the lower bound is proved. A formal description of the optimal hedging strategy as a succession of periods of classical Black–Scholes hedging strategy and simple buy‐and‐hold strategy is also provided.

Date: 2007
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