Hedging Strategies in Discrete Time GOOD SLIDE Angelini 2007

Outline
The problem
The optimal strategy
The Delta strategy
Transaction costs
Applications
Conclusions
Hedging strategies in discrete time
Flavio Angelini, Stefano Herzel
University of Perugia
30 April - 5 May 2007, II AMAMEF Conference
Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Introduction
I Most mathematical models for financial markets assume

continuous-time trading
I Strategies that are optimal in continuous time (e.g. BS delta
hedging) need not to be optimal in discrete time
I Can we effectively compute a discrete time optimal strategy?
I Can we measure the error due to time discretization?

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Introduction


Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Introduction


Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Introduction


Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The setting
I Let H be the payoff of a contingent claim

I Let S = (Sk )N N
k=0 be the asset price process and ϑ = (ϑk )k=1
be the hedging ratio of a self-financing trading strategy
I Assume zero interest rate
I The gains process is
N
X
GN (ϑ) = ϑj ∆Sj
j=1
where ∆Sj = Sj − Sj−1

I Given an initial value c, follow the strategy ϑ. The hedging
error is
ε(ϑ, c) = H − c − GN (ϑ)
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The setting

I Let S = (Sk )N N
N
X
GN (ϑ) = ϑj ∆Sj
j=1

error is
ε(ϑ, c) = H − c − GN (ϑ)
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The setting

I Let S = (Sk )N N
N
X
GN (ϑ) = ϑj ∆Sj
j=1

error is
ε(ϑ, c) = H − c − GN (ϑ)
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The setting

I Let S = (Sk )N N
N
X
GN (ϑ) = ϑj ∆Sj
j=1

error is
ε(ϑ, c) = H − c − GN (ϑ)
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The setting

I Let S = (Sk )N N
N
X
GN (ϑ) = ϑj ∆Sj
j=1

error is
ε(ϑ, c) = H − c − GN (ϑ)
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The discretization error in the BS model
BS hedging
0.25
0.2
0.15
0.1
0.05
0
−10 −8 −6 −4 −2 0 2 4 6 8 10
N=12, N=180

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem
I Measurement of hedging error

I Minimization Problem:
min E ε(ϑ, c)2

ϑ∈Θ
for fixed c ∈ IR
I Computation of
E ε(ϑ, c)2

for given c, ϑ

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem

min E ε(ϑ, c)2

ϑ∈Θ
for fixed c ∈ IR
I Computation of
E ε(ϑ, c)2

for given c, ϑ

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The problem

min E ε(ϑ, c)2

ϑ∈Θ
for fixed c ∈ IR
I Computation of
E ε(ϑ, c)2

for given c, ϑ

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The existence of the optimal strategy
I Assume that process X satisfies the following Non-Degeneracy

(ND) condition:
(Ek−1 ∆Sk )2
<M
vark−1 ∆Sk
for all ω and k.
I Then there exists a unique optimal trading strategy θc that
solves the basic problem (Schweizer (1995))
I A counterexample shows that the ND condition is necessary
for the existence of a solution
I If X is a (non degenerate) martingale then condition ND is
obviously satisfied
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The structure of the optimal strategy
I In general, the explicit computation of the optimal strategy is

a very hard task
I Schweizer (1995): ”The optimal hedge ratio can be
decomposed in 3 pieces: locally optimal (pure hedging
demand) ξ H , demand for mean-variance purposes, demand for
hedging against mean-variance ratio stochastic changes (not
present if the m.v.r. is deterministic)”.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The Laplace transform approach
I Hubalek, Kallsen and Krawczyk (2006), C̆erný (2007)

I Let (Ω, F, (Fn )n∈(0,1,...,N) , P) be a filtered probability space.
Consider a one-dimensional process
Sn = S0 exp(Xn ),
where the process X = (Xn ) for n = 0, 1, . . . , N, satisfies

1. X is adapted to the filtration Fn , n ∈ (0, 1, . . . , N),
2. X0 = 0,
3. ∆Xn = Xn − Xn−1 n = 1, . . . , N are i.i.d.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Sn = S0 exp(Xn ),

2. X0 = 0,
3. ∆Xn = Xn − Xn−1 n = 1, . . . , N are i.i.d.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Sn = S0 exp(Xn ),

2. X0 = 0,
3. ∆Xn = Xn − Xn−1 n = 1, . . . , N are i.i.d.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Sn = S0 exp(Xn ),

2. X0 = 0,
3. ∆Xn = Xn − Xn−1 n = 1, . . . , N are i.i.d.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Sn = S0 exp(Xn ),

2. X0 = 0,
3. ∆Xn = Xn − Xn−1 n = 1, . . . , N are i.i.d.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
I Can compute the moment generating function of ∆X
m(z) = E [e z∆X ],
assuming that it exists for 0 ≤ Re(z) ≤ 2

I A rather general class of models, including Black-Scholes,
Merton jump-diffusion, NIG, etc.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
I Can compute the moment generating function of ∆X
m(z) = E [e z∆X ],
assuming that it exists for 0 ≤ Re(z) ≤ 2

I A rather general class of models, including Black-Scholes,
Merton jump-diffusion, NIG, etc.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The idea of the Laplace transform approach
I An exponential claim is a contingent claim with payoff
H(z) = SNz = S0z e zXN
I The i.i.d. assumption for ∆Xn makes computations easy for

exponential claims.
I Consider a contingent claim which is a ”linear combination”
of exponential claims (let us call it a simple claim)
I Use linearity properties and Fubini

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

exponential claims.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

exponential claims.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

exponential claims.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
I More precisely consider contingent claims whose payoff is an

inverse Laplace Transform
Z
H = SNz Π(dz)
I A European call is a simple claim!

R+i∞
K 1−z
Z
1 +
(SN − K ) = SNz dz,
2πi R−i∞ z(z − 1)
with R > 1 arbitrary

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
I More precisely consider contingent claims whose payoff is an

inverse Laplace Transform
Z
H = SNz Π(dz)
I A European call is a simple claim!

R+i∞
K 1−z
Z
1 +
(SN − K ) = SNz dz,
2πi R−i∞ z(z − 1)
with R > 1 arbitrary

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The results
I Locally optimal hedge ratio at 0
Z
ξ1 = S0z−1 g (z)h(z)N−1 Π(dz)
I Value at 0 of the optimal portfolio

Z
V0 = S0z h(z)N−1 Π(dz)
I Optimal variance
Z Z
Var0 = J0 (y , z)Π(dy )Π(dz)

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The results
Z
ξ1 = S0z−1 g (z)h(z)N−1 Π(dz)

Z
I Optimal variance
Z Z

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The results
Z
ξ1 = S0z−1 g (z)h(z)N−1 Π(dz)

Z
I Optimal variance
Z Z

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
A relevant question
I Everyday market practice adopts classical Delta hedging

I Other easily implementable hedging strategies have also been
proposed (e.g. Willmott)
I Can we measure the variance of a given (non-optimal)
strategy?

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
A relevant question

strategy?

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
A relevant question

strategy?

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Delta hedging, previous results
I Let ϑ = ∆N be the BS-delta and S is the BS-process.

I Hayashi and Mykland (2005) showed that
r Z T
T
N
ε(∆ , c) − Γu σ 2 Su2 dWu∗ → 0
2N 0

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
I Let ϑ = ∆N be the BS-delta and S is the BS-process.

I Hayashi and Mykland (2005) showed that
r Z T
T
N
ε(∆ , c) − Γu σ 2 Su2 dWu∗ → 0
2N 0

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
I Toft (1996) provides an asymptotic approximation for the

variance
N−1
1 4 T 2X
E0 (Γk Sk2 )2

σ
2 N
k=0
I Kamal and Derman (1999) propose a more trader-friendly

approximation
π 2
σ Vega2
4N

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
I Toft (1996) provides an asymptotic approximation for the

variance
N−1
1 4 T 2X
E0 (Γk Sk2 )2

σ
2 N
k=0
I Kamal and Derman (1999) propose a more trader-friendly

approximation
π 2
σ Vega2
4N

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Crucial observation
I The Delta of a simple claim is an inverse Laplace transform
Z
z−1
∆n = f (z)n Sn−1 Π(dz),
where f (z)n = zm0 (z)N−n+1 does not depend on Sn−1 .

I The price at time tn−1 of a simple claim is
Z
Q z
Pn−1 = En−1 SN Π(dz)
Z Z
Q z z
= En−1 [SN ]Π(dz) = Sn−1 m0 (z)N−n+1 Π(dz),
Q
where En−1 is the pricing measure and m0 (z) is the m.g.f. of
corresponding ∆X .
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Crucial observation
I The Delta of a simple claim is an inverse Laplace transform
Z
z−1
∆n = f (z)n Sn−1 Π(dz),
where f (z)n = zm0 (z)N−n+1 does not depend on Sn−1 .

I The price at time tn−1 of a simple claim is
Z
Q z
Pn−1 = En−1 SN Π(dz)
Z Z
Q z z
= En−1 [SN ]Π(dz) = Sn−1 m0 (z)N−n+1 Π(dz),
Q
where En−1 is the pricing measure and m0 (z) is the m.g.f. of
corresponding ∆X .
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Delta hedging error
I The hedging error of a simple claim is an inverse Laplace

transform
Z
H − c − GN (∆) = (H(z) − c − GN (∆(z)))Π(dz)
I Can compute expected value and variance of the hedging error

if I am able to compute things inside the integral

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Delta hedging error
I The hedging error of a simple claim is an inverse Laplace

transform
Z
H − c − GN (∆) = (H(z) − c − GN (∆(z)))Π(dz)
I Can compute expected value and variance of the hedging error

if I am able to compute things inside the integral

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Expected value
I Z Z
E [H] = E [SNz ]Π(dz) = S0z m(z)N Π(dz)
I
Z
z−1
E [∆n ∆Sn ] = E [f (z)n Sn−1 ∆Sn ]Π(dz)
Z
= S0z f (z)n (m(1) − 1)m(z)n−1 Π(dz),
for n = 1, . . . , N

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Expected value
I Z Z
E [H] = E [SNz ]Π(dz) = S0z m(z)N Π(dz)
I
Z
z−1
E [∆n ∆Sn ] = E [f (z)n Sn−1 ∆Sn ]Π(dz)
Z
= S0z f (z)n (m(1) − 1)m(z)n−1 Π(dz),
for n = 1, . . . , N

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Variance of Delta hedging
I Need to compute all the covariances

I
E [H(y )H(z)] = E [SNy SNz ] = S0y +z m(y + z)N
I
z
E [H(y )Sn−1 ∆Sn ] = E [SNy Sn−1
z
∆Sn ] = S0y +z v2 (y , z)n ,
where v2 (y , z)n depends on m.g.f., N and n = 1, . . . , N

I
y
E [Sn−1 z
Sm−1 ∆Sn ∆Sm ] = S0y +z v3 (y , z)n,m ,
where v3 (y , z)n,m depends on m.g.f., N and n, m = 1, . . . , N
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

I
I
z
z
∆Sn ] = S0y +z v2 (y , z)n ,

I
y
E [Sn−1 z
Sm−1 ∆Sn ∆Sm ] = S0y +z v3 (y , z)n,m ,
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

I
I
z
z
∆Sn ] = S0y +z v2 (y , z)n ,

I
y
E [Sn−1 z
Sm−1 ∆Sn ∆Sm ] = S0y +z v3 (y , z)n,m ,
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

I
I
z
z
∆Sn ] = S0y +z v2 (y , z)n ,

I
y
E [Sn−1 z
Sm−1 ∆Sn ∆Sm ] = S0y +z v3 (y , z)n,m ,
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The main result

I For a simple claim and any ϑ given by
Z
z−1
ϑn = f (z)n Sn−1 Π(dz),
N
Z " #
X
E [ε(ϑ, 0)] = S0z N
m(z) − (m(1) − 1) f (z)k m(z) k−1
Π(dz)
k=1
Z Z
E [ε(ϑ, 0) ] = 2
S0y +z V (y , z)Π(dz)Π(dy ),
I Examples of strategies: BS-Delta, Wilmott ”improved delta”,

local optimal (already in C̆erný (2007))
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The main result

Z
z−1
N
Z " #
X
E [ε(ϑ, 0)] = S0z N
m(z) − (m(1) − 1) f (z)k m(z) k−1
Π(dz)
k=1
Z Z
E [ε(ϑ, 0) ] = 2

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
The main result

Z
z−1
N
Z " #
X
E [ε(ϑ, 0)] = S0z N
m(z) − (m(1) − 1) f (z)k m(z) k−1
Π(dz)
k=1
Z Z
E [ε(ϑ, 0) ] = 2

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Comments
I With same technique may in principle compute moments of

higher order
I Can choose a strategy (”f (z)n ”) and a model (”m(z)”)
I In particular, one can measure the hedging error of the Delta
strategy for different data generating processes
I The result can be extended to the case of ∆Xn not identically
distributed

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Comments

higher order
distributed

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Comments

higher order
distributed

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Comments

higher order
distributed

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Transaction costs
I With same technique can include transaction costs.
I
1
TCn = κSn |∆n+1 − ∆n |,
2
for n = 1, . . . , N − 1
1
TCN = κSN |∆N |
2
I
N
X
ε(ϑ, c) = H − c − GN (ϑ) + TCn .
n=1
I No results about optimal strategy
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Transaction costs
I
1
TCn = κSn |∆n+1 − ∆n |,
2
for n = 1, . . . , N − 1
1
TCN = κSN |∆N |
2
I
N
X
ε(ϑ, c) = H − c − GN (ϑ) + TCn .
n=1
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Transaction costs
I
1
TCn = κSn |∆n+1 − ∆n |,
2
for n = 1, . . . , N − 1
1
TCN = κSN |∆N |
2
I
N
X
ε(ϑ, c) = H − c − GN (ϑ) + TCn .
n=1
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Transaction costs
I
1
TCn = κSn |∆n+1 − ∆n |,
2
for n = 1, . . . , N − 1
1
TCN = κSN |∆N |
2
I
N
X
ε(ϑ, c) = H − c − GN (ϑ) + TCn .
n=1
Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Transaction costs
I For a simple (and increasing in the underlying as the Delta)

strategy can be written too as an inverse Laplace transform
because
|∆n+1 − ∆n | = 1∆Xn >0 2(∆n+1 − ∆n ) − (∆n+1 − ∆n )
I Can compute the variance of transaction costs and the

covariance with other terms by computing
m+ (z) = E [1∆X >0 e z∆X ]

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Transaction costs
I For a simple (and increasing in the underlying as the Delta)

strategy can be written too as an inverse Laplace transform
because
|∆n+1 − ∆n | = 1∆Xn >0 2(∆n+1 − ∆n ) − (∆n+1 − ∆n )
I Can compute the variance of transaction costs and the

covariance with other terms by computing
m+ (z) = E [1∆X >0 e z∆X ]

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Applications
I Assess precision of existing approximations of the variance

I How worse than optimal-variance is Delta hedging?
I Compare performances of various strategies for different
models
I To measure performances use Sharpe ratio
−E [ε(ϑ, c)]
s(ϑ, c) = p
var(ε(ϑ, c))

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Applications

models
−E [ε(ϑ, c)]
s(ϑ, c) = p
var(ε(ϑ, c))

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Applications

models
−E [ε(ϑ, c)]
s(ϑ, c) = p
var(ε(ϑ, c))

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The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Applications

models
−E [ε(ϑ, c)]
s(ϑ, c) = p
var(ε(ϑ, c))

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Relative errors of approximations of standard deviation
0.2
kdvega
kd
0.15
0.1
0.05
−0.05
0 10 20 30 40 50 60 70
N

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The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Model risk
I Data generating process: Merton jump-diffusion process with

normally distributed jumps, with returns with annual mean
µ ≈ 0.14 and volatility σ ≈ 0.44
I Hedging ratios: B-S Delta and B-S locally optimal computed
with parameters µ and σ, Merton optimal
I ATM Call option (K = 100), T = 3 months, number of
trading dates from 1 to 65

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Model risk


Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Model risk


Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Model risk
Sharpe index of different strategies
0.07
0.06
0.05
0.04
0.03
0.02 opt
delta
loc opt bs
0.01
0
0 10 20 30 40 50 60 70
N

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The Delta strategy
Transaction costs
Applications
Conclusions
Model mispecification
I Data generating process: Black-Scholes model with given µ

and σ
I Hedging ratios: B-S Delta and B-S local optimal computed
with parameters µ0 and σ0 = 0.3
I If σ < σ0 expect a gain from trading strategy

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The problem
The Delta strategy
Transaction costs
Applications
Conclusions

and σ

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The problem
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Applications
Conclusions

and σ

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The problem
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Transaction costs
Applications
Conclusions

and σ

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The problem
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Transaction costs
Applications
Conclusions
Sharpe index as a function of realized volatility σ, with

µ0 = µ = 0.1 and N = 10
5
delta
loc. opt.
−1
−2
0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5
σ

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The problem
The Delta strategy
Transaction costs
Applications
Conclusions
s(∆) − s(ξ H ) as a function of σ, for different µ (σ0 = 0.3,

µ0 = 0.1)
0.01
−0.01
−0.02
−0.03
−0.04
−0.05
−0.06 µ = 0
µ =0.1
µ =−0.1
−0.07
−0.08
0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5

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The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Sharpe index of local optimal strategy as a function of σ

and µ (σ0 = 0.3, µ0 = 0, S = K = 100, N = 10)
−1
−2
−3
−4
−5
0.5
0.4 0.2
0.1
0.3
0
0.2
−0.1
0.1 −0.2
σ
µ

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Conclusions
I We have an efficient way to compute moments of hedging

errors of strategies in presence of transaction costs for simple
claims and for a wide class of data generating process
I This allows to measure the performance of hedging strategies
in different settings, for instance under model mispecification
I Need to study the effect of transaction costs
I Is it possible to find optimal strategy? Or best hedging
volatility?
I Robust hedging
I Multi-dimensional

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The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Conclusions

volatility?
I Robust hedging
I Multi-dimensional

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Conclusions

volatility?
I Robust hedging
I Multi-dimensional

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Conclusions

volatility?
I Robust hedging
I Multi-dimensional

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Conclusions

volatility?
I Robust hedging
I Multi-dimensional

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Conclusions

volatility?
I Robust hedging
I Multi-dimensional

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Appendix: Inverse Laplace transform
I The (one-dimensional) Inverse Laplace transform is

Z R+i∞
1
f (t) = L−1 {F (s)} = e st F (s)ds
2πi R−i∞
I There are several algorithms that perform numerical inversion

of the Laplace transform in an efficient way
I The computation of variance involve a double dimensional
inversion. This is usually a harder task.

Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Z R+i∞
1
f (t) = L−1 {F (s)} = e st F (s)ds
2πi R−i∞


Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions

Z R+i∞
1
f (t) = L−1 {F (s)} = e st F (s)ds
2πi R−i∞


Outline
The problem
The Delta strategy
Transaction costs
Applications
Conclusions
Appendix: Numerical implementation
I The formulas we wish to compute involve one- and

two-dimensional Laplace transforms.
I There are at least two possible approaches: numerical
integration and inversion of Laplace transform.
I Second approach, implementing the algorithms in MATLAB.
I One-dimensional case: we used ”invlap.m” constructed by
Hollenbeck (1998), very accurate
I Bi-dimensional case: we wrote a code based on Choudhury,
Lucantoni, Whitt (1994), quite accurate.

Hedging Strategies in Discrete Time GOOD SLIDE Angelini 2007

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Hedging Strategies in Discrete Time GOOD SLIDE Angelini 2007

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Outline

Hedging strategies in discrete time

Flavio Angelini, Stefano Herzel

30 April - 5 May 2007, II AMAMEF Conference

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The optimal strategy

The Delta strategy

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The optimal strategy

The Delta strategy

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The optimal strategy

The Delta strategy

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The optimal strategy

The Delta strategy

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The optimal strategy

The Delta strategy

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The optimal strategy

The Delta strategy

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

I Most mathematical models for financial markets assume

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

I Most mathematical models for financial markets assume

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

I Most mathematical models for financial markets assume

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

I Most mathematical models for financial markets assume

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

I Let H be the payoff of a contingent claim

where ∆Sj = Sj − Sj−1

I Let H be the payoff of a contingent claim

where ∆Sj = Sj − Sj−1

I Let H be the payoff of a contingent claim

where ∆Sj = Sj − Sj−1

I Let H be the payoff of a contingent claim

where ∆Sj = Sj − Sj−1

I Let H be the payoff of a contingent claim

where ∆Sj = Sj − Sj−1

The discretization error in the BS model

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

I Measurement of hedging error

min E ε(ϑ, c)2

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

I Measurement of hedging error

min E ε(ϑ, c)2

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

I Measurement of hedging error

min E ε(ϑ, c)2

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The existence of the optimal strategy

I Assume that process X satisfies the following Non-Degeneracy

The structure of the optimal strategy

I In general, the explicit computation of the optimal strategy is

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The Laplace transform approach

I Hubalek, Kallsen and Krawczyk (2006), C̆erný (2007)

where the process X = (Xn ) for n = 0, 1, . . . , N, satisfies

Flavio Angelini, Stefano Herzel Hedging strategies in discrete time

The Laplace transform approach

I Hubalek, Kallsen and Krawczyk (2006), C̆erný (2007)

where the process X = (Xn ) for n = 0, 1, . . . , N, satisfies