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

Birbeck Working Paper No. 0508

47 Pages Posted: 5 Oct 2006

See all articles by Álvaro Cartea

Álvaro Cartea

University of Oxford; University of Oxford - Oxford-Man Institute of Quantitative Finance

Date Written: May 2005

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 Gamma-neutrality 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.

Keywords: Delta hedging, Gamma Hedging, Jump Processes, Portfolio Hedging

JEL Classification: G12, G13, G22

Suggested Citation

Cartea, Álvaro, Dynamic Hedging of Financial Instruments When the Underlying Follows a Non-Gaussian Process (May 2005). Birbeck Working Paper No. 0508, Available at SSRN: https://ssrn.com/abstract=934812 or http://dx.doi.org/10.2139/ssrn.934812

Álvaro Cartea (Contact Author)

University of Oxford ( email )

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University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

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