HEDGING AND ARBITRAGE WARRANTS UNDER SMILE EFFECTS: ANALYSIS AND EVIDENCE

Son-Nan Chen, An-Pin Chen and Camus Chang
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Son-Nan Chen: Department of Banking, National Cheng Chi University, Taiwan, ROC
An-Pin Chen: Institute of Information Management, National Chiao Tung University, Taiwan, ROC
Camus Chang: Institute of Information Management, National Chiao Tung University, Taiwan, ROC

International Journal of Theoretical and Applied Finance (IJTAF), 2001, vol. 04, issue 05, 733-758

Abstract: While the Black–Scholes (BS) model and binomial trees assume that the stock price evolves lognormally with constant volatility, volatility smiles are pronounced in almost all the worlds equity markets. To study the effects of volatility smiles on hedging and arbitrage, the method based on the BS model and implemented with observed market volatility smiles is proposed. The empirical results indicate that the proposed model can reduce risk exposure and increase profits on hedging as compared with the BS model, and hence leading to considerable returns on arbitrage-trading in the Taiwan warrant market. The model is proven to be not only useful for warrant issuers who attempt to reduce vega risk, but also practicable for investors to implement as arbitrage strategies under smile effects.

Keywords: Volatility smile; implied volatility; warrant; hedge; arbitrage (search for similar items in EconPapers)
Date: 2001
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DOI: 10.1142/S0219024901001255

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