The Value of Timing Risk

Jiro Akahori, Flavia Barsotti and Yuri Imamura

Papers from arXiv.org

Abstract: The aim of this paper is to provide a mathematical contribution on the semi-static hedge of timing risk associated to positions in American-style options under a multi-dimensional market model. Barrier options are considered in the paper and semi-static hedges are studied and discussed for a fairly large class of underlying price dynamics. Timing risk is identified with the uncertainty associated to the time at which the payoff payment of the barrier option is due. Starting from the work by Carr and Picron (1999), where the authors show that the timing risk can be hedged via static positions in plain vanilla options, the present paper extends the static hedge formula proposed in Carr and Picron (1999) by giving sufficient conditions to decompose a generalized timing risk into an integral of knock-in options in a multi-dimensional market model. A dedicated study of the semi-static hedge is then conducted by defining the corresponding strategy based on positions in barrier options. The proposed methodology allows to construct not only first order hedges but also higher order semi-static hedges, that can be interpreted as asymptotic expansions of the hedging error. The convergence of these higher order semi-static hedges to an exact hedge is shown. An illustration of the main theoretical results is provided for i) a symmetric case, ii) a one dimensional case, where the first order and second order hedging errors are derived in analytic closed form. The materiality of the hedging benefit gain of going from order one to order two by re-iterating the timing risk hedging strategy is discussed through numerical evidences by showing that order two can bring to more than 90% reduction of the hedging 'cost' w.r.t. order one (depending on the specific barrier option characteristics).

Date: 2017-01
New Economics Papers: this item is included in nep-rmg
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