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Hedging derivatives with model error

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  • Robert A. Jarrow

Abstract

The current derivatives pricing technology enables users to hedge derivatives with the underlying asset or any other traded derivative. In theory, there is no reason to prefer one hedging instrument to another. However, given model errors, this is not true. Imposing some simple assumptions on the structure of model errors, this paper shows that to maximize hedging accuracy, there is an ordering to the hedging instruments utilized. Holding constant market illiquidities, one should always hedge first with ‘like’ derivatives, next with derivatives one layer down the hierarchy of derivatives, and lastly using the underlying.

Suggested Citation

  • Robert A. Jarrow, 2012. "Hedging derivatives with model error," Quantitative Finance, Taylor & Francis Journals, vol. 12(6), pages 855-863, February.
    • Handle: RePEc:taf:quantf:v:12:y:2012:i:6:p:855-863
    DOI: 10.1080/14697688.2011.564201
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    References listed on IDEAS

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    1. Baxter,Martin & Rennie,Andrew, 1996. "Financial Calculus," Cambridge Books, Cambridge University Press, number 9780521552899, September.
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    Cited by:

    1. Detering, Nils & Packham, Natalie, 2018. "Model risk of contingent claims," IRTG 1792 Discussion Papers 2018-036, Humboldt University of Berlin, International Research Training Group 1792 "High Dimensional Nonstationary Time Series".

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