Effectiveness of Hedging Strategies Under Model Misspecification and Trading Restrictions

25 Pages Posted: 9 Mar 2002

Date Written: June 12, 2002

Abstract

The following paper focuses on the incompleteness arising from model misspecification combined with trading restrictions. While asset price dynamics are assumed to be continuous time processes, the hedging of contingent claims occurs in discrete time. The trading strategies under consideration are understood to be self-financing with respect to an assumed model which may deviate from the "true" model, thus associating duplication costs with respect to a contingent claim to be hedged. Based on the robustness result of Gaussian hedging strategies, saying that a superhedge is achieved for convex payoff functions if the "true" asset price volatility is dominated by the assumed one, the error of time discretising these strategies is analysed. It turns out that the time discretisation of Gaussian hedges gives rise to a duplication bias caused by asset price trends, which can be avoided by discretising the hedging model instead of discretising the hedging strategies. Additionally, it is shown that on the one hand binomial strategies incorporate similar robustness features as Gaussian hedges. On the other hand, the distribution of the cost process associated with the binomial hedge coincides with the distribution of the cost process associated with the Gaussian hedge in the limit. Together, the last results yield a strong argument in favour of discretising the hedge model instead of time discretising the strategies.

Keywords: Hedging, Model Misspecification, Trading Restrictions, Superhedging

JEL Classification: G13

Suggested Citation

Mahayni, Antje B., Effectiveness of Hedging Strategies Under Model Misspecification and Trading Restrictions (June 12, 2002). Available at SSRN: https://ssrn.com/abstract=302909 or http://dx.doi.org/10.2139/ssrn.302909

Antje B. Mahayni (Contact Author)

Mercator School of Management ( email )

Lotharstraße 65
Duisburg, Nordrhein-Westfalen 47057
Germany

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