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An improved framework for approximating option prices with application to option portfolio hedging

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  • Mozumder, Sharif
  • Dempsey, Michael
  • Kabir, M. Humayun
  • Choudhry, Taufiq

Abstract

As the price of the underlying asset changes over time, delta of the option changes and a gamma hedge is required along with delta hedge to reduce risk. This paper develops an improved framework to compute delta and gamma values with the average of a range of underlying prices rather than at the conventional fixed ‘one point’. We find that models with time-varying volatility price options satisfactorily, and perform remarkably well in combination with the delta and delta-gamma approximations. Significant improvements are achieved for the GARCH model followed by stochastic volatility models. The new approach can ensure significant improvement in modelling option prices leading to better risk-management decision-making.

Suggested Citation

  • Mozumder, Sharif & Dempsey, Michael & Kabir, M. Humayun & Choudhry, Taufiq, 2016. "An improved framework for approximating option prices with application to option portfolio hedging," Economic Modelling, Elsevier, vol. 59(C), pages 285-296.
    • Handle: RePEc:eee:ecmode:v:59:y:2016:i:c:p:285-296
    DOI: 10.1016/j.econmod.2016.07.023
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