This research compares partial equilibrium and statistical time-series approaches to hedging. The finance literature stresses the former approach, while the applied economics literature has focused on the latter. We compare the out-of-sample hedging effectiveness of the two approaches when hedging commodity price risk using futures contracts. For various methods of parameter estimation and infe...

The Quanto option is a cash-settled, cross-currency derivative in which the underlying asset has a payoff in one country, but the payoff is converted to another currency in which the option is settled. Thus, the correlation between the underlying asset and currency exchange rate plays an important role on pricing such options. Market observations give clear evidence that financial quantities ar...

We present a theory of option pricing and hedging, designed to address non-perfect arbitrage, market friction and the presence of ‘fat’ tails. An implied volatility ‘smile’ is predicted. We give precise estimates of the residual risk associated with optimal (but imperfect) hedging. Accepted for publication in Risk Magazine (December 1995).

We present the pricing and hedging method for options with general payoffs in the presence of transaction costs. The convexity of the payoff function gamma of the options is an important issue under transaction costs. When the payoff function is convex, Leland-style pricing and hedging method still works. However, if the payoff function is of general form, additional assumptions on the size of ...

We analyze the pricing and hedging of catastrophe put options under stochastic interest rates with losses generated by a compound Poisson process. Asset prices are modeled through a jump-diffusion process which is correlated to the loss process. We obtain explicit closed form formulae for the price of the option, and the hedging parameters Delta, Gamma and Rho. The effects of stochastic interes...

This paper analyzes a risk averse entrepreneur’s real investment decision under incomplete markets. The entrepreneur smoothes his intertemporal consumption by investing in both a risk-free asset and a risky asset, which allows him to partially hedge against the project cash flow risk. We show that risk aversion lowers both the project value upon investment and the option value of waiting to inv...

In this paper we provide a technique for pricing exotics relative to the instruments used for hedging them, while making minimal assumptions about price processes. The issue we address is this: given the prices of a set of hedging assets (such as a stock and a set of traded European options on that stock), what restrictions can be placed on the price of an exotic option? The question has a natu...

SPRING 2000 THE JOURNAL OF DERIVATIVES 1 Option prices can reveal implied (risk-neutral) distributions, but it is not clear whether these are useful for forecasting or hedging or for revealing the current sentiment of investors. The authors estimate the implied distribution for stock index options in London as a mixture of two lognormals over the period 1987-1997 and find that this method is mu...