Risk-minimization hedging under nonoptimal exercising

Dmitriy Levchenkov, Thomas F. Coleman, Yuying Li

Abstract

ABSTRACT

Many complex options (for example, options embedded in insurance contracts) have an early exercising feature. It is important to evaluate the impact of the nonoptimal exercising in the pricing and risk management of these options. We consider the problem of discrete hedging under irrational exercising. We propose a framework under which irrational exercising is modeled explicitly and local risk-minimization hedging strategies can be computed. We evaluate quadratic and piecewise linear risk-minimization approaches in this framework and compare hedging performance between different hedging strategies. In addition, we compare hedging effectiveness under irrational exercising with that of European contracts and American contracts with optimal exercising.We find that irrational exercising may have a significant impact on discrete-hedging strategies and hedging costs.