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Dynamic Hedging

In: THE ECONOMIC FOUNDATIONS OF RISK MANAGEMENT Theory, Practice, and Applications

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  • Robert Jarrow

Abstract

Under a complete market, dynamic hedging enables one to synthetically construct any derivative. The ability to synthetically construct implies the ability to remove all risks. When markets are incomplete, synthetic construction is usually impossible. In this case, dynamic hedging only enables one to super- and sub-replicate the payoffs to any derivative. To use dynamic hedging we need to assume an evolution for the underlying traded assets. For simplicity of the presentation, we assume that there is no interest rate risk and restrict ourselves to the market in Chapter 3. The subsequent analysis can easily be extended to include interest rate risk using the HJM model in Chapter 4. The same methodology presented below applies, but in an extended fashion with more complex notation.

Suggested Citation

  • Robert Jarrow, 2017. "Dynamic Hedging," World Scientific Book Chapters, in: THE ECONOMIC FOUNDATIONS OF RISK MANAGEMENT Theory, Practice, and Applications, chapter 15, pages 115-125, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789813147522_0015
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    More about this item

    Keywords

    Risk Management; Derivatives; Value-at-Risk; Funding Risk; Financial Engineering;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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