Option Pricing and Hedging in the Presence of Basis Risk

This paper addresses the problem of option hedging and pricing when a futures contract, written either on the underlying asset or on some imperfectly correlated substitute for the underlying asset, is used in the dynamic replication of the option payoff.

Author(s) :

Lionel Martellini

Professor of finance, EDHEC Business School and scientific director, EDHEC-Risk Institute

Vincent Milhau

Research engineer, EDHEC-Risk Institute

Presentation :

In the presence of unspanned basis risk modeled as a Brownian bridge process, which explicitly accounts for the convergence of the basis to zero as the futures contract approaches maturity, we are able to obtain an analytical expression for the optimal hedging strategy and corresponding option price. Empirical analysis suggests that the hedging demand against basis risk is an important ingredient of the hedging strategy. For reasonable parameter values, we also find the replication error implied by the optimal strategy to be substantially lower than that implied by heuristic strategies routinely used in practice.
Pdf
Option Pricing and Hedging in the Presence of Basis Risk...
(1.48 MB)
Type : Working paper
Date : le 22/02/2011
Extra information : For more information, please contact Joanne Finlay, EDHEC Research and Development Department [ joanne.finlay@edhec.edu ] The contents of this paper do not necessarily reflect the opinions of EDHEC Business School.
Research Cluster : Finance

See Also

EDHEC consolidates its position as a world-leading school for business and entrepreneurship
- 03-07-2017
Founded by entrepreneurs, EDHEC has embraced the fundamental values of business for...
Station F successfully inaugurated in the presence of Emmanuel Macron and EDHEC
- 29-06-2017
EDHEC announced this May that it had joined Station F, the world’s biggest start-up...
- 22-06-2017
Peter Daly and Dennis Davy, professors at EDHEC Business School specialised in Language...
Financial Times ranking 2017: #1 Master in Finance Worldwide
- 19-06-2017
EDHEC Business School’s Master in Finance tops the Financial Times Masters in Finance...