Robust Hedging in Incomplete Markets

31 Pages Posted: 10 Feb 2017 Last revised: 28 Feb 2018

See all articles by Sally Shen

Sally Shen

Global Risk Institute; Netspar

Antoon Pelsser

Maastricht University; Netspar

Peter C. Schotman

Maastricht University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: January 18, 2018

Abstract

We develop a robust optimal dynamic hedging strategy that takes both downside risks and market incompleteness into account for an agent who fears model misspecification. The robust agent is assumed to minimize the shortfall between the assets and liabilities under an endogenous worst case scenario by means of solving a min-max robust optimization problem. When the funding ratio is low, robustness reduces the demand for risky assets. However, cherishing the hope of covering the liabilities, a substantial risk exposure is still optimal. A longer investment horizon or a higher funding ratio weakens the investor’s fear of model misspecification. If the expected equity return is overestimated, the initial capital requirement for hedging can be decreased by following the robust strategy.

Keywords: Model misspecification, robust optimization, uncertainty set, incomplete market, dynamic hedging, explicit finite difference, expected shortfall

JEL Classification: G11; G13

Suggested Citation

Shen, Sally and Pelsser, Antoon A. J. and Schotman, Peter C., Robust Hedging in Incomplete Markets (January 18, 2018). Netspar Discussion Paper No. 08/2014-064, Available at SSRN: https://ssrn.com/abstract=2564481 or http://dx.doi.org/10.2139/ssrn.2564481

Sally Shen

Global Risk Institute ( email )

55 University Avenue, Suite 1801
Toronto, ON M5J 2H7
Canada

Netspar ( email )

P.O. Box 90153
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Antoon A. J. Pelsser

Maastricht University ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands

HOME PAGE: http://https://sites.google.com/site/apelsseraca/

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Peter C. Schotman (Contact Author)

Maastricht University - Department of Finance ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands
+31 43 388 3862 (Phone)
+31 43 388 4875 (Fax)

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