1.Department of Mathematics,University of Michigan,Ann Arbor,USA;2.Department IV – Mathematics,Universit?t Trier,Trier,Germany
Abstract:
We study the pricing and hedging of derivative securities with uncertainty about the volatility of the underlying asset. Rather than taking all models from a prespecified class equally seriously, we penalise less plausible ones based on their “distance” to a reference local volatility model. In the limit for small uncertainty aversion, this leads to explicit formulas for prices and hedging strategies in terms of the security’s cash gamma.