Journal
QUANTITATIVE FINANCE
Volume 9, Issue 6, Pages 693-704Publisher
ROUTLEDGE JOURNALS, TAYLOR & FRANCIS LTD
DOI: 10.1080/14697680902852738
Keywords
Locally risk-minimizing delta hedge; Stochastic volatility; Model risk; Empirical hedge performance
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Funding
- Swiss National Center of Competence in Research 'Financial Valuation and Risk Management' (NCCR FINRISK)
- Danish Center for Accounting and Finance (D-CAF)
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In this paper the performance of locally risk-minimizing delta hedge strategies for European options in stochastic volatility models is studied from an experimental as well as from an empirical perspective. These hedge strategies are derived for a large class of diffusion-type stochastic volatility models, and they are as easy to implement as usual delta hedges. Our simulation results on model risk show that these risk-minimizing hedges are robust with respect to uncertainty and misconceptions about the underlying data generating process. The empirical study, which includes the US sub-prime crisis period, documents that in equity markets risk-minimizing delta hedges consistently outperform usual delta hedges by approximately halving the standard deviation of the profit-and-loss ratio.
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