Optimal positioning in derivative securities in incomplete markets

Tim Leung, Matthew Lorig and Yoshihiro Shirai

Papers from arXiv.org

Abstract: This paper analyzes a problem of optimal static hedging using derivatives in incomplete markets. The investor is assumed to have a risk exposure to two underlying assets. The hedging instruments are vanilla options written on a single underlying asset. The hedging problem is formulated as a utility maximization problem whereby the form of the optimal static hedge is determined. Among our results, a semi-analytical solution for the optimizer is found through variational methods for exponential, power/logarithmic, and quadratic utility. When vanilla options are available for each underlying asset, the optimal solution is related to the fixed points of a Lipschitz map. In the case of exponential utility, there is only one such fixed point, and subsequent iterations of the map converge to it.

Date: 2024-02
New Economics Papers: this item is included in nep-rmg and nep-upt
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