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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Status of publication | Published |
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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 |