Hedging portfolios of financial guarantees

ABSTRACT We propose a framework in the manner of Davis et al (1993) and Whalley and Wilmott (1997) to study dynamic hedging strategies on portfolios of financial guarantees in the presence of transaction costs. We contrast four dynamic hedging strategies including a utility-based dynamic hedging strategy, in conjunction with using an asset-based index, with the strategy of no hedging. For the proposed utility-based strategy, the portfolio rebalancing is triggered by the tradeoff between transaction costs and utility gains. Overall, using a Froot and Stein (1998) and Perold (2005) type of risk-adjusted performance measurement metric, we find the utility-based strategy to be a good compromise between the delta hedging strategy and the passive stance of doing nothing. This result is even stronger with higher transaction costs. However, if the insured firms’ assets are not traded or are in a high transaction costs environment, the guarantor can use an indexbased security as hedging instrument.