Optimal Hedging of a Contingent Claim with Ambiguity Aversion

50 Pages Posted: 28 Jul 2012

Date Written: July 27, 2012

Abstract

We propose a model of hedging and investment with ambiguity aversion in an incomplete financial market. We show that the agent's worst-case belief depends upon the payoff of the derivative to be hedged. Thus, we identify situations where one can distinguish ambiguity averse agents from probabilistically sophisticated agents. Further, we generate the hypothesis: an ambiguity averse agent chooses higher volatility when hedging a derivative position whose payoff function is convex than when hedging a position whose payoff function is concave. Our model can be extended to accommodate non-iid uncertainty and jumps in the continuous time limit of the model.

Keywords: Ambiguity, Hedging, Incomplete Market, Minimax Expected Utility, Rectangularity

JEL Classification: C61, D81, G11

Suggested Citation

Hyun, Chongseok and Koo, Hyeng Keun, Optimal Hedging of a Contingent Claim with Ambiguity Aversion (July 27, 2012). Available at SSRN: https://ssrn.com/abstract=2118434 or http://dx.doi.org/10.2139/ssrn.2118434

Chongseok Hyun (Contact Author)

Ajou University ( email )

Dasan Hall 505, San 5, Woncheon-dong
Youngtong-gu
Suwon, 443749
Korea, Republic of (South Korea)
82-31-219-3661 (Phone)
82-31-219-3664 (Fax)

HOME PAGE: http://fe.ajou.ac.kr

Hyeng Keun Koo

Ajou University ( email )

206 Worldcup-ro
Yeongtong-gu
Suwon, 443-749
Korea, Republic of (South Korea)
82-31-219-2706 (Phone)
82-31-219-1616 (Fax)

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