Stochastic Alpha-Beta-Rho Hedging for Foreign Exchange Options: Is It Worth the Effort?

Abstract

This article applies the stochastic alpha-beta-rho (SABR) model to the foreign exchange options market. The model pricing and hedging performance are tested using three years of historical data from August 2, 2010 to July 31, 2013 for the four most traded currency pairs. The results are compared to the hedging performance of the Black–Scholes model. The empirical study shows that the SABR model can fit and predict market volatility well. However, the hedging results show that the SABR model does not provide a more accurate hedge ratio than the Black–Scholes model. This finding is surprising given the well-known criticism of the Black–Scholes model.