Hedging Derivatives Risks - a Simulation Study

This paper undertakes a simulation study to investigate (a) the performance of alternative hedging strategies against various derivatives risks and (b) the impact of model misspecification on hedging performance. The hedging strategies considered in this paper include the single-instrument hedge, the delta-neutral hedge, and the ad hoc Black-Scholes delta-vega-(rho)-neutral hedge, while the risk factors of the derivatives include the underlying asset return risk, stochastic volatility risk, stochastic interest rate risk, and random jump or market crash risk. In addition, we investigate the performance of the delta-neutral hedge with the use of potentially traded volatility derivatives. Our simulation results provide guidance for how a risk factor can be hedged based on certain hedging strategies and evidence of how severe model risk can be when hedging strategies are based on misspecified models