A moment computation algorithm for the error in discrete dynamic hedging |
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| Institution: | 1. Aarhus University, Fuglesangs Allé 4, 8210 Aarhus V, Denmark;2. Department of Economics and Finance, Robert C. Vackar College of Business and Entrepreneurship, University of Texas Rio Grande Valley, Brownsville, TX 78520, United States;3. Department of Finance, Muma College of Business, BSN3403, University of South Florida, Tampa, FL 33620, United States;1. Discipline of Finance, The University of Sydney Business School, The University of Sydney, N.S.W. 2006, Australia;2. Finance Discipline Group, University of Technology Sydney, Broadway, N.S.W. 2007, Australia;3. Research School of Finance, Actuarial Studies and Applied Statistics, The Australian National University, Canberra, A.C.T. 0200, Australia |
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| Abstract: | This paper develops a computational approach to determining the moments of the distribution of the error in a dynamic hedging or payoff replication strategy under discrete trading. In particular, an algorithm is developed for portfolio affine trading strategies, which lead to portfolio dynamics that are affine in the portfolio variable. This structure can be exploited in the computation of moments of the hedging error of such a strategy, leading to a lattice based backward recursion similar in nature to lattice based pricing techniques, but not requiring the portfolio variable. We use this algorithm to analyze the performance of portfolio affine hedging strategies under discrete trading through the moments of the hedging error. |
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