Dynamic Hedging of Financial Instruments When the Underlying Follows a Non-Gaussian Process

Álvaro Cartea ()

No 508, Birkbeck Working Papers in Economics and Finance from Birkbeck, Department of Economics, Mathematics & Statistics

Abstract: Traditional dynamic hedging strategies are based on local information (ie Delta and Gamma) of the financial instruments to be hedged. We propose a new dynamic hedging strategy that employs non-local information and compare the profit and loss (P&L) resulting from hedging vanilla options when the classical approach of Delta- and Gammaneutrality is employed, to the results delivered by what we label Delta- and Fractional-Gamma-hedging. For specific cases, such as the FMLS of Carr and Wu (2003a) and Merton’s Jump-Diffusion model, the volatility of the P&L is considerably lower (in some cases only 25%) than that resulting from Delta- and Gamma-neutrality.

Date: 2005-05
New Economics Papers: this item is included in nep-fin and nep-rmg
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https://eprints.bbk.ac.uk/id/eprint/27035 First version, 2005 (application/pdf)

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