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Calibration and hedging under jump diffusion |
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| Authors: | C He J S Kennedy T F Coleman P A Forsyth Y Li K R Vetzal |
| Institution: | (1) J.P. Morgan Securities Inc., 270 Park Ave, Floor 6, New York, NY, 10017-2070, USA;(2) Department of Applied Mathematics, University of Waterloo, Waterloo, ON, Canada, N2L 3G1;(3) Department of Combinatorics and Optimization, University of Waterloo, Waterloo, ON, Canada, N2L 3G1;(4) David R. Cheriton School of Computer Science, University of Waterloo, Waterloo, ON, Canada, N2L 3G1;(5) Centre for Advanced Studies in Finance, University of Waterloo, Waterloo, ON, Canada, N2L 3G1 |
| Abstract: | A jump diffusion model coupled with a local volatility function has been suggested by Andersen and Andreasen (2000). By generating a set of option prices assuming a jump diffusion with known parameters, we investigate two crucial challenges intrinsic to this type of model: calibration of parameters and hedging of jump risk. Even though the estimation problem is ill-posed, our results suggest that the model can be calibrated with sufficient accuracy. Two different strategies are explored for hedging jump risk: a semi-static approach and a dynamic technique. Simulation experiments indicate that each of these methods can sharply reduce risk exposure. JEL Classification G12 · G13 |
| Keywords: | Jump diffusion Calibration Static hedging Dynamic hedging |
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