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An examination of the effectiveness of static hedging in the presence of stochastic volatility
Author(s) -
Fink Jason
Publication year - 2003
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.10089
Subject(s) - econometrics , stochastic volatility , hedge , volatility (finance) , economics , sabr volatility model , volatility smile , implied volatility , cash , mathematics , finance , ecology , biology
Toft and Xuan (1998) use simulation evidence to demonstrate that the static hedging method of Dermanet al. (1995) performs inadequately when volatility is stochastic. Particularly, the greater the“volatility of volatility,” the poorer the static hedge. This article presents an alternative statichedging methodology, denoted the generalized static hedge, that appears to perform more reliably. Specifically,the value, delta, and vega of the static hedges closely approximate those values of the barrier option beinghedged. Further, simulation evidence indicates that when volatility of volatility is large, the standarddeviation of simulated cash flows from the generalized static hedge position is less than the standard deviationof simulated cash flows from previously defined static hedge positions. © 2003 Wiley Periodicals, Inc. JrlFut Mark 23:859–890, 2003