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Option pricing and hedging with minimum local expected shortfall

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Abstract

We propose a versatile Monte-Carlo method for pricing and hedging options when the market is incomplete, for an arbitrary risk criterion (chosen here to be the expected shortfall), for a large class of stochastic processes, and in the presence of transaction costs. We illustrate the method on plain vanilla options when the price returns follow a Student-t distribution. We show that in the presence of fat-tails, our strategy allows to significantly reduce extreme risks, and generically leads to low Gamma hedging. Similarly, the inclusion of transaction costs reduces the Gamma of the optimal strategy.

Dates and versions

hal-00133198 , version 1 (23-02-2007)

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Benoît Pochart, Jean-Philippe Bouchaud. Option pricing and hedging with minimum local expected shortfall. 2003. ⟨hal-00133198⟩
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