Optimal hedging of a perpetual American put with a single trade

Cheng Cai, Tiziano De Angelis and Jan Palczewski

Papers from arXiv.org

Abstract: It is well-known that using delta hedging to hedge financial options is not feasible in practice. Traders often rely on discrete-time hedging strategies based on fixed trading times or fixed trading prices (i.e., trades only occur if the underlying asset's price reaches some predetermined values). Motivated by this insight and with the aim of obtaining explicit solutions, we consider the seller of a perpetual American put option who can hedge her portfolio once until the underlying stock price leaves a certain range of values $(a,b)$. We determine optimal trading boundaries as functions of the initial stock holding, and an optimal hedging strategy for a bond/stock portfolio. Optimality here refers to the variance of the hedging error at the (random) time when the stock leaves the interval $(a,b)$. Our study leads to analytical expressions for both the optimal boundaries and the optimal stock holding, which can be evaluated numerically with no effort.

Date: 2020-03, Revised 2020-09
New Economics Papers: this item is included in nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:2003.06249

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