TY - JOUR
T1 - Static Hedging of Timing Risk
JF - The Journal of Derivatives
SP - 57
LP - 70
DO - 10.3905/jod.1999.319119
VL - 6
IS - 3
AU - Carr, Peter
AU - Picron, Jean-Francois
Y1 - 1999/02/28
UR - http://jod.pm-research.com/content/6/3/57.abstract
N2 - The standard theoretical approach to option valuation as well as delta-based option hedging, involves continuous trading between the underlying asset and riskless bonds. But in practice, of course, transaction costs make frequent rebalancing of an option replicating portfolio very expensive. It can be much cheaper to hedge an option with a static portfolio containing a well-designed set of options and other securities. Exact replication will not be possible, but delta-hedging is not exact in the real world either. This article shows the useful and somewhat surprising result that a reasonable static hedging strategy exists even for barrier options for which there is timing uncertainty regarding when the barrier is hit. Carr and Picron first describe the strategy conceptually in terms of a few artificial types of derivatives, such as a “pseudo-share or nothing call.” They then show how these building block securities can be replicated by portfolios of simple European calls and puts. Simulation result show that the static hedges are cheaper and more accurate than those derived from a standard delta-hedging technique.
ER -