Hedging with Small Uncertainty Aversion
48 Pages Posted: 3 Jul 2015 Last revised: 17 Apr 2017
Date Written: May 20, 2016
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.
Keywords: volatility uncertainty, ambiguity aversion, option pricing and hedging, asymptotics
JEL Classification: G13, C61, C73
Suggested Citation: Suggested Citation
Herrmann, Sebastian and Muhle-Karbe, Johannes and Seifried, Frank Thomas, Hedging with Small Uncertainty Aversion (May 20, 2016). Finance and Stochastics, Vol. 21, No. 1, pp. 1-64, 2017, Swiss Finance Institute Research Paper No. 15-19, Available at SSRN: https://ssrn.com/abstract=2625965 or http://dx.doi.org/10.2139/ssrn.2625965
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