Optimal Market Completion through Financial Derivatives with Applications to Volatility Risk

Matt Davison, Marcos Escobar-Anel () and Yichen Zhu
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Matt Davison: Department of Statistical and Actuarial Sciences, Western University, London, ON N6A 3K7, Canada
Marcos Escobar-Anel: Department of Statistical and Actuarial Sciences, Western University, London, ON N6A 3K7, Canada
Yichen Zhu: Department of Statistical and Actuarial Sciences, Western University, London, ON N6A 3K7, Canada
Authors registered in the RePEc Author Service: Marcos Escobar Anel ()

JRFM, 2024, vol. 17, issue 10, 1-20

Abstract: This paper investigates the optimal choices of financial derivatives to complete a financial market in the framework of stochastic volatility (SV) models. We first introduce an efficient and accurate simulation-based method applicable to generalized diffusion models to approximate the optimal derivatives-based portfolio strategy. We build upon a double optimization approach, i.e., expected utility maximization and risk exposure minimization, already proposed in the literature, demonstrating that strangle options are the best choices for market completion within equity options. They lead to lower investors’ risk exposure for a wide range of strikes compared to the lesser flexibility of calls, puts, and strangles. Furthermore, we explore the benefit of using volatility index derivatives and conclude that they could be more convenient substitutes when short-term maturity equity options are not available.

Keywords: expected utility theory; constant relative risk aversion (CRRA) utility; optimal derivative choice; volatility risk; volatility index (VIX) options (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2024
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Working Paper: Optimal market completion through financial derivatives with applications to volatility risk (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:gam:jjrfmx:v:17:y:2024:i:10:p:457-:d:1494361

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