Option Valuation and Hedging Strategies with Jumps in the Volatility of Asset Returns.

Abstract

The author develops a model in which the volatility of risky assets is subject to random and discontinuous shifts over time. The author derives prices of claims contingent on such assets and analyzes options-based trading strategies to hedge against the risk of jumps in the return volatility. Unsystematic and systematic events, such as takeovers, major changes in business plans, or shifts in economic policy regimes, may drastically alter firms' risk portfolios. The author's model captures the effect of such events on options markets. Copyright 1993 by American Finance Association.