Is Foreign Exchange Delta Hedging Risk Priced?

FRB of St. Louis Working Paper No. 2004-029A

47 Pages Posted: 13 Jan 2005

See all articles by Hui Guo

Hui Guo

University of Cincinnati - Department of Finance - Real Estate

Christopher J. Neely

Federal Reserve Bank of St. Louis - Research Division

Date Written: November 2004

Abstract

If there is no priced risk - including volatility risk - associated with hedging an option, then expected delta hedging errors should be zero. This paper finds that delta hedging errors of a synthetic at-the-money call option on foreign exchange futures are significantly positive and cannot be explained by standard asset pricing models. However, we cannot rule out the hypothesis that delta hedging errors reflect rational pricing; foreign exchange volatility and stock market volatility predict them. Moreover, foreign exchange volatility also predicts excess stock market returns, indicating that foreign exchange volatility risk might be priced because of its relation to foreign exchange level risk.

Keywords: Exchange rate, option, implied volatility, realized volatility, asset pricing

JEL Classification: F31, G51

Suggested Citation

Guo, Hui and Neely, Christopher J., Is Foreign Exchange Delta Hedging Risk Priced? (November 2004). FRB of St. Louis Working Paper No. 2004-029A, Available at SSRN: https://ssrn.com/abstract=648105 or http://dx.doi.org/10.2139/ssrn.648105

Hui Guo (Contact Author)

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business
418 Carl H. Lindner Hall
Cincinnati, OH 45221
United States
513.556.7077 (Phone)
513.556.0979 (Fax)

HOME PAGE: http://homepages.uc.edu/~guohu/

Christopher J. Neely

Federal Reserve Bank of St. Louis - Research Division ( email )

411 Locust St
Saint Louis, MO 63011
United States
314-444-8568 (Phone)
314-444-8731 (Fax)

HOME PAGE: http://www.stls.frb.org/research/econ/cneely/

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