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Risk minimization in stochastic volatility models: model risk and empirical performance

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  • Rolf Poulsen
  • Klaus Reiner Schenk-Hoppe
  • Christian-Oliver Ewald

Abstract

In this paper the performance of locally risk-minimizing delta hedge strategies for European options in stochastic volatility models is studied from an experimental as well as from an empirical perspective. These hedge strategies are derived for a large class of diffusion-type stochastic volatility models, and they are as easy to implement as usual delta hedges. Our simulation results on model risk show that these risk-minimizing hedges are robust with respect to uncertainty and misconceptions about the underlying data generating process. The empirical study, which includes the US sub-prime crisis period, documents that in equity markets risk-minimizing delta hedges consistently outperform usual delta hedges by approximately halving the standard deviation of the profit-and-loss ratio.

Suggested Citation

  • Rolf Poulsen & Klaus Reiner Schenk-Hoppe & Christian-Oliver Ewald, 2009. "Risk minimization in stochastic volatility models: model risk and empirical performance," Quantitative Finance, Taylor & Francis Journals, vol. 9(6), pages 693-704.
    • Handle: RePEc:taf:quantf:v:9:y:2009:i:6:p:693-704
    DOI: 10.1080/14697680902852738
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    References listed on IDEAS

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