Pricing and hedging contingent claims using variance and higher order moment swaps

Leonidas Rompolis and Elias Tzavalis

Quantitative Finance, 2017, vol. 17, issue 4, 531-550

Abstract: This paper suggests perfect hedging strategies of contingent claims under stochastic volatility and random jumps of the underlying asset price. This is done by enlarging the market with appropriate swaps whose pay-offs depend on higher order sample moments of the asset price process. Using European options and variance swaps, as well as barrier options written on the S&P 500 index, the paper provides clear cut evidence that hedging strategies employing variance and higher order moment swaps considerably improves upon the performance of traditional delta hedging strategies. Inclusion of the third-order moment swap improves upon the performance of variance swap-based strategies to hedge against random jumps. This result is more profound for short-term out-of-the money put options.

Date: 2017
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DOI: 10.1080/14697688.2016.1224373

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