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Hedging Surprises, Jumps, and Model Misspecification: A Risk Management Perspective on Hedging S&P 500 Options

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  • Andreas Kaeck

Abstract

This article provides comprehensive tests of alternative jump-diffusion models for the purpose of hedging S&P 500 options. We explicitly take into account the risk arising from price and variance jumps and assess the hedging performance by focusing on the ability of competing specifications to forecast hedging errors. To this end, we devise density prediction tests and find evidence that jumps are important features of S&P 500 index dynamics. All jump-diffusion models tested in this article show signs of misspecification, but the inclusion of jumps can improve the hedging performance and risk assessment, especially in two-instrument hedges. Copyright 2013, Oxford University Press.

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  • Andreas Kaeck, 2013. "Hedging Surprises, Jumps, and Model Misspecification: A Risk Management Perspective on Hedging S&P 500 Options," Review of Finance, European Finance Association, vol. 17(4), pages 1535-1569.
    • Handle: RePEc:oup:revfin:v:17:y:2013:i:4:p:1535-1569
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    File URL: http://hdl.handle.net/10.1093/rof/rfs027
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    Cited by:

    1. Audrino, Francesco & Fengler, Matthias R., 2015. "Are classical option pricing models consistent with observed option second-order moments? Evidence from high-frequency data," Journal of Banking & Finance, Elsevier, vol. 61(C), pages 46-63.
    2. Leonidas S. Rompolis & Elias Tzavalis, 2017. "Pricing and hedging contingent claims using variance and higher order moment swaps," Quantitative Finance, Taylor & Francis Journals, vol. 17(4), pages 531-550, April.
    3. Maciej Augustyniak & Alexandru Badescu & Mathieu Boudreault, 2023. "On the Measurement of Hedging Effectiveness for Long-Term Investment Guarantees," JRFM, MDPI, vol. 16(2), pages 1-18, February.
    4. Harish S. Bhat & Nitesh Kumar, 2015. "Large-Scale Empirical Tests of the Markov Tree Model," IJFS, MDPI, vol. 3(3), pages 1-39, July.
    5. Marek Nagy & Katarina Valaskova & Erika Kovalova & Marcel Macura, 2024. "Drivers of S&P 500’s Profitability: Implications for Investment Strategy and Risk Management," Economies, MDPI, vol. 12(4), pages 1-24, March.
    6. Neumann, Maximilian & Prokopczuk, Marcel & Wese Simen, Chardin, 2016. "Jump and variance risk premia in the S&P 500," Journal of Banking & Finance, Elsevier, vol. 69(C), pages 72-83.
    7. Augustyniak, Maciej & Badescu, Alexandru & Bégin, Jean-François, 2023. "A discrete-time hedging framework with multiple factors and fat tails: On what matters," Journal of Econometrics, Elsevier, vol. 232(2), pages 416-444.
    8. Xiao, Yuewen & Zhao, Jing, 2021. "Price dynamics of individual stocks: Jumps and information," Finance Research Letters, Elsevier, vol. 38(C).

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