Stochastic Volatility: Risk Minimization and Model Risk

In this paper locally risk-minimizing hedge strategies for European-style contingent claims are derived and tested for a general class of stochastic volatility models. These strategies are as easy to implement as ordinary delta hedges, yet in realistic settings they produce markedly lower hedge errors. Our experimental investigations on model risk furthermore show that locally risk-minimizing hedges are robust with respect to parameter uncertainty as well as misspecifications of the stochastic volatility model.