Author : Klaus Bjerre Toft
Publisher :
ISBN 13 :
Total Pages : pages
Book Rating : 4.:/5 (129 download)
Book Synopsis How Well Can Barrier Options Be Hedged by a Static Portfolio of Standard Options? by : Klaus Bjerre Toft
Download or read book How Well Can Barrier Options Be Hedged by a Static Portfolio of Standard Options? written by Klaus Bjerre Toft and published by . This book was released on 1998 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: Derman, Ergener, and Kani (1994) construct static hedges of barrier options by assuming that local asset return volatility is a function of asset price and time only. However, Dumas, Fleming, and Whaley (1996) find that local volatilities implied from Samp;P 500 index option prices change in a nonpredictable fashion. It is therefore important to determine how sensitive the quality of a static barrier option hedge is to random changes in local volatilities. We investigate this issue by assuming that options are priced according to Heston's (1993) stochastic volatility model, and use these prices to construct static hedges of up and out barrier options. We then identify distributions of cash flows from these hedges by simulating asset price and volatility paths. Our simulations show that static hedges replicate barrier options quite well if the volatility of volatility is moderate or if the barrier option's payoff does not exhibit discontinuities. However, if the payoff on the boundary is noncontinuous, the quality of the static hedge deteriorates rapidly when the volatility of the volatility is large. This happens because a static hedge typically overhedges the volatility exposure of the target barrier option.