Quotation Frey, Rüdiger. 2000. Market Illiquidities as a Source of Model Risk in Dynamic Hedging. In: Model Risk, Hrsg. Rajna Gibson, 125-138. London: Risk Publications.


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Abstract

In the present paper we study market illiquidity as a particular source of model risk in the hedging of derivatives. We depart from the usual Black-Scholes framework, where it is assumed that option hedgers are small traders, and consider a model where the implementation of a hedging strategy affects the price of the underlying security. We derive a formula for the feedback-effect of dynamic hedging on market volatility and present a formula for the hedging error due to market illiquidity. We go on and characterize perfect hedging strategies by a nonlinear version of the Black-Scholes PDE. We relate this PDE to other models for the risk-management of derivatives under market frictions and present some simulations.

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Publication's profile

Status of publication Published
Affiliation WU
Type of publication Chapter in edited volume
Language English
Title Market Illiquidities as a Source of Model Risk in Dynamic Hedging
Title of whole publication Model Risk
Editor Rajna Gibson
Page from 125
Page to 138
Location London
Publisher Risk Publications
Year 2000
ISBN 1899332898

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Frey, Rüdiger (Details)
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Institute for Statistics and Mathematics IN (Details)
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