Model Risk Adjusted Hedge Ratios

27 Pages Posted: 9 May 2010

See all articles by Carol Alexander

Carol Alexander

University of Sussex Business School; Peking University HSBC Business School

Andreas Kaeck

University of Sussex

Leonardo M. Nogueira

Banco Central do Brasil - Foreign Reserves Department; University of Reading - ICMA Centre

Date Written: March 3, 2009

Abstract

Most option pricing models assume all parameters except volatility are fixed; yet they almost invariably change on re-calibration. This paper explains how to capture the model risk that arises when parameters that are assumed constant have calibrated values that change over time and how to use this model risk to adjust the price hedge ratios of the model. Empirical results demonstrate an improvement in hedging performance after the model risk adjustment.

Keywords: delta hedge, model risk

JEL Classification: G1

Suggested Citation

Alexander, Carol and Kaeck, Andreas and Nogueira, Leonardo M., Model Risk Adjusted Hedge Ratios (March 3, 2009). Available at SSRN: https://ssrn.com/abstract=1601229 or http://dx.doi.org/10.2139/ssrn.1601229

Carol Alexander (Contact Author)

University of Sussex Business School ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.coalexander.com

Peking University HSBC Business School ( email )

Andreas Kaeck

University of Sussex ( email )

Sussex House
Falmer
Brighton, Sussex BNI 9RH
United Kingdom

Leonardo M. Nogueira

Banco Central do Brasil - Foreign Reserves Department ( email )

SBS Quadra 3 Bloco B, 5o andar
Ed. Sede Bacen
Brasilia, 70074-900
Brazil

HOME PAGE: http://www.bcb.gov.br

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
+44 (0)1183 786675 (Phone)
+44 (0)1189 314741 (Fax)

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