Department of Economics and Business Economics

It Only Takes a Few Moments to Hedge

Research output: Working paperResearch

Traders hedge the risks carried by options and other securities using the so-called Greeks, with the delta and the vega being the most prominent. In this paper, we propose a novel non-structural method for hedging European options, relying on two model-independent results: First, under suitable regularity conditions on the risk-neutral density, an option price can be disentangled into a linear combination of risk-neutral moments. Second, there exists an explicit functional form linking the risk-neutral moments to the price of the underlying asset and the related variance swap contracts. We show that, historically, S&P 500 call prices are mainly explained by two factors that are related to level and volatility of the underlying index. Based on this, we devise and empirically compare the hedging performance of two strategies where the vega exposure is adjusted either by taking a direct position in variance swap contracts or, indirectly, through an ATM call option. While both strategies ensure effective immunization in periods of market turmoil, taking direct exposure on volatility might not be optimal during extended periods of subdued market volatility. We argue that this result is related to the phenomenon known as the "low VIX puzzle".
Original languageEnglish
Place of publicationRochester, NY
PublisherSocial Science Research Network (SSRN)
Number of pages25
Publication statusPublished - 12 Dec 2017

    Research areas

  • option Greeks, hedging, risk-neutral moments, low VIX puzzle

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