Model Risk Analysis for Entropic Hedging Strategies

Paul McCloud

Papers from arXiv.org

Abstract: Market incompleteness causes residual profit and loss after hedging that is accounted for with valuation adjustments and bid-offer spreads acting as model risk buffers for the derivative price. Entropic risk optimisation is a general framework for modelling these adjustments. When the prices are quadratic Gaussian, the coupled equations for price and hedge ratios are solved exactly, with a decomposition of the entropic risk into convexity, dimensionality, funding and strategy contributions that are attributed in the explanation of realised P&L. The results are applicable when the underlying prices follow Gaussian processes, such as fractional Ornstein-Uhlenbeck processes. The article concludes with analysis of the continuous hedging limit for these processes, and a discussion of their application in data-driven regressions.

Date: 2026-10, Revised 2026-11
New Economics Papers: this item is included in nep-inv and nep-rmg
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