Hedging derivatives with model error |
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Authors: | Robert A. Jarrow |
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Affiliation: | 1. Cornell University , 451 Sage Hall, Ithaca , NY 14853 , USA raj15@cornell.edu |
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Abstract: | The current derivatives pricing technology enables users to hedge derivatives with the underlying asset or any other traded derivative. In theory, there is no reason to prefer one hedging instrument to another. However, given model errors, this is not true. Imposing some simple assumptions on the structure of model errors, this paper shows that to maximize hedging accuracy, there is an ordering to the hedging instruments utilized. Holding constant market illiquidities, one should always hedge first with ‘like’ derivatives, next with derivatives one layer down the hierarchy of derivatives, and lastly using the underlying. |
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Keywords: | Derivatives hedging Derivatives risk management Hedging errors Hedging techniques |
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