Simple Robust Hedging with Nearby Contracts

Liuren Wu and Jingyi Zhu

Journal of Financial Econometrics, 2017, vol. 15, issue 1, 1-35

Abstract: This paper proposes a new hedging strategy based on approximate matching of contract characteristics instead of risk sensitivities. The strategy hedges an option with three options at different maturities and strikes by matching the option function expansion along maturity and strike rather than risk factors. Its hedging effectiveness varies with the maturity and strike distance between the target and the hedge options, but is robust to variations in the underlying risk dynamics. Simulation analysis under different risk environments and historical analysis on S&P 500 index options both show that a wide spectrum of strike-maturity combinations can outperform dynamic delta hedging.

Keywords: characteristics matching; hedging; jumps; Monte Carlo; payoff matching; risk sensitivity matching; strike-maturity triangle; stochastic volatility; S&P 500 index options; Taylor expansion (search for similar items in EconPapers)
JEL-codes: G11 G13 (search for similar items in EconPapers)
Date: 2017
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