Journal of Risk Model Validation
ISSN:
1753-9579 (print)
1753-9587 (online)
Editor-in-chief: Steve Satchell
Does hedging with implied volatility factors improve the hedging efficiency of barrier options?
Szymon Borak, Matthias R. Fengler and Wolfgang K. Härdle
Abstract
ABSTRACT
The price of a barrier option depends on the shape of the entire implied volatility surface which is a high-dimensional dynamic object. Barrier options are hence exposed to non-trivial volatility risk. We extract the key risk factors of implied volatility surface fluctuations by means of a semiparametric factor model. Based on the factors we define a practical hedging procedure within a local volatility framework. The hedging performance is evaluated using DAX index options.
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