Dynamic Hedging of Financial Instruments When the Underlying Follows a Non-Gaussian Process
Birbeck Working Paper No. 0508
47 Pages Posted: 5 Oct 2006
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: Suggested Citation