Hedging for the long run

Hardy Hulley*, Eckhard Platen

*Corresponding author for this work

Research output: Contribution to journalArticle

4 Citations (Scopus)

Abstract

In the years following the publication of Black and Scholes (J Political Econ, 81(3), 637-654, 1973), numerous alternative models have been proposed for pricing and hedging equity derivatives. Prominent examples include stochastic volatility models, jump-diffusion models, and models based on Lévy processes. These all have their own shortcomings, and evidence suggests that none is up to the task of satisfactorily pricing and hedging extremely long-dated claims. Since they all fall within the ambit of risk-neutral valuation, it is natural to speculate that the deficiencies of these models are (at least in part) attributable to the constraints imposed by the risk-neutral approach itself. To investigate this idea, we present a simple two-parameter model for a diversified equity accumulation index. Although our model does not admit an equivalent risk-neutral probability measure, it nevertheless fulfils a minimal no-arbitrage condition for an economically viable financial market. Furthermore, we demonstrate that contingent claims can be priced and hedged, without the need for an equivalent change of probability measure. Convenient formulae for the prices and hedge ratios of a number of standard European claims are derived, and a series of hedge experiments for extremely long-dated claims on the S&P 500 total return index are conducted. Our model serves also as a convenient medium for illustrating and clarifying several points on asset price bubbles and the economics of arbitrage.

Original languageEnglish
Pages (from-to)105-124
Number of pages20
JournalMathematics and Financial Economics
Volume6
Issue number2
DOIs
Publication statusPublished - May 2012
Externally publishedYes

Keywords

  • Arbitrage
  • Asset price bubbles
  • Hedge simulations
  • Long-dated claims
  • Minimal market model
  • Real-world valuation
  • Risk-neutral valuation
  • Squared Bessel processes

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