7,803 research outputs found
A non-arbitrage liquidity model with observable parameters for derivatives
We develop a parameterised model for liquidity effects arising from the trading in an asset. Liquidity is defined via a combination of a trader's individual transaction cost and a price slippage impact, which is felt by all market participants. The chosen definition allows liquidity to be observable in a centralised order-book of an asset as is usually provided in most non-specialist exchanges. The discrete-time version of the model is based on the CRR binomial tree and in the appropriate continuous-time limits we derive various nonlinear partial differential equations. Both versions can be directly applied to the pricing and hedging of options; the nonlinear nature of liquidity leads to natural bid-ask spreads that are based on the liquidity of the market for the underlying and the existence of (super-)replication strategies. We test and calibrate our model set-up empirically with high-frequency data of German blue chips and discuss further extensions to the model, including stochastic liquidity
International Trade, Hedging and the Demand for Forward Contracts
One of the main results of the literature on the effects of uncertainty on trade states that uncertainty should not matter in the presence of well developed forward markets. Empirical studies, however, do not support this result. We derive the demand for forward cover in a small open economy with terms of trade uncertainty. Adopting a standard and more realistic decision structure than the one usually used in this literature, we find that risk averse agents will not buy forwards at an unbiased price. Agents treat forward contracts as an asset rather than as an insurance. This is the reason why, when calibrating the model, only 17% of imports are covered by forwards. --
Hedging Brevity Risk with Mortality-based Securities
In 2003, Swiss Re introduced a mortality-based security designed to hedge excessive mortality changes for its life book of business. The concern was apparently brevity risk, i.e., the risk of premature death. The brevity risk due to a pandemic is similar to the property risk associated with catastrophic events such as earthquakes and hurricanes and the security used to hedge the risk is similar to a CAT bond. This work looks at the incentives associated with insurance-linked securities. It considers the trade-offs an insurer or reinsurer faces in selecting a hedging strategy. We compare index and indemnity-based hedging as alternative design choices and ask which is capable of creating the greater value for shareholders. Additionally, we model an insurer or reinsurer that is subject to insolvency risk, which creates an incentive problem known as the judgment proof problem. The corporate manager is assumed to act in the interests of shareholders and so the judgment proof problem yields a conflict of interest between shareholders and other stakeholders. Given the fact that hedging may improve the situation, the analysis addresses what type of hedging tool would be best to use. We show that an indemnity-based security tends to worsen the situation, as it introduces an additional incentive problem. Index-based hedging, on the other hand, under certain conditions turns out to be beneficial and therefore clearly dominates indemnity-based strategies. This result is further supported by showing that for the same strike prices the current shareholder value is greater with the index-based security than the indemnity-based security
Option pricing and hedging with minimum local expected shortfall
We propose a versatile Monte-Carlo method for pricing and hedging options
when the market is incomplete, for an arbitrary risk criterion (chosen here to
be the expected shortfall), for a large class of stochastic processes, and in
the presence of transaction costs. We illustrate the method on plain vanilla
options when the price returns follow a Student-t distribution. We show that in
the presence of fat-tails, our strategy allows to significantly reduce extreme
risks, and generically leads to low Gamma hedging. Similarly, the inclusion of
transaction costs reduces the Gamma of the optimal strategy.Comment: 23 pages, 7 figures, 8 table
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