OPTIMAL STATIC–DYNAMIC HEDGES FOR BARRIER OPTIONS |
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Authors: | Aytaç lhan Ronnie Sircar |
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Institution: | Mathematical Institute, University of Oxford; Department of Operations Research and Financial Engineering, Princeton University |
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Abstract: | We study optimal hedging of barrier options, using a combination of a static position in vanilla options and dynamic trading of the underlying asset. The problem reduces to computing the Fenchel–Legendre transform of the utility-indifference price as a function of the number of vanilla options used to hedge. Using the well-known duality between exponential utility and relative entropy, we provide a new characterization of the indifference price in terms of the minimal entropy measure, and give conditions guaranteeing differentiability and strict convexity in the hedging quantity, and hence a unique solution to the hedging problem. We discuss computational approaches within the context of Markovian stochastic volatility models. |
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Keywords: | hedging derivative securities stochastic control indifference pricing stochastic volatility |
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