The Optimal Alternative to the Delta Hedge in the Black and Scholes' (1973) World

24 Pages Posted: 23 May 2010 Last revised: 27 May 2010

See all articles by Katarzyna Romaniuk

Katarzyna Romaniuk

Université de Paris 1 Panthéon-Sorbonne; Xi'an Jiaotong-Liverpool University (XJTLU)

Date Written: May 26, 2010

Abstract

The delta hedge, constituting the benchmark method when covering a position in an option, does not define the optimal investment strategy, even in the original Black and Scholes (1973)’ (BS) setting. We propose the definition of the optimal alternative to the delta neutral cover in the original BS world, using the Merton (1971)’s optimal asset allocation model. The solution derived can be seen as the optimal hedging strategy for a position in an option, or, more generally, as the optimal portfolio rule in the case of an optional payoff. Optimal portfolios composed of an option, the underlying stock and (possibly) the riskless asset are considered. It is shown that the optimal solution each time incorporates the pure delta neutral hedge, this first term being augmented by a - possibly modified - speculative fund. The results prove that, by going from the case without riskless asset to the one characterized by its presence, the general principles driving the pure delta neutral strategy do not always hold anymore.

Keywords: Delta Hedge, Optimal Hedge, Optimal Portfolio, Optional Payoff, Stochastic Dynamic Programming

JEL Classification: C61, G11, G13

Suggested Citation

Romaniuk, Katarzyna, The Optimal Alternative to the Delta Hedge in the Black and Scholes' (1973) World (May 26, 2010). Available at SSRN: https://ssrn.com/abstract=1613243 or http://dx.doi.org/10.2139/ssrn.1613243

Katarzyna Romaniuk (Contact Author)

Université de Paris 1 Panthéon-Sorbonne ( email )

17, rue de la Sorbonne
Paris, 75005
France

Xi'an Jiaotong-Liverpool University (XJTLU) ( email )

111 Renai Road, SIP
Suzhou, JiangSu province 215123
China

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
151
Abstract Views
970
rank
232,740
PlumX Metrics