EconStor >
Rheinische Friedrich-Wilhelms-Universität Bonn >
Bonn Graduate School of Economics (BGSE), Universität Bonn >
Bonn Econ Discussion Papers, Bonn Graduate School of Economics (BGSE), Universität Bonn >

Please use this identifier to cite or link to this item:

http://hdl.handle.net/10419/22959
  
Title:Hedging Basket Options by Using a Subset of Underlying Assets PDF Logo
Authors:Su, Xia
Issue Date:2006
Series/Report no.:Bonn econ discussion papers 2006,14
Abstract:This paper proposes two-step static hedging strategies for European basket options by using only plain-vanilla options on a subset of underlying assets. The basic idea is stimulated from a static super-hedging strategy dependent on the whole basket. However, it would be too complicated to handle when there is a large number of assets in the basket. It becomes even worse when some of the underlying assets are illiquid or not available for trading. Meanwhile, this strategy completely neglects the correlation structure of the basket which has indeed a great effect on the basket option?s price. To solve these problems, Principal Components Analysis is used to figure out the subset of dominant assets through a careful study on the modified covariance of the basket. On this basis, the optimal strikes of those significant assets? plain-vanilla options are obtained in the second step via optimization. The optimality criterion depends on the risk attitude of hedgers and is defined by a certain risk measure, e.g., super-replication, minimum expected shortfall given a constraint on the hedging cost. Through analyzing a numerical example, it is concluded that this static hedging portfolio captures a trade-off between reduced hedging costs and overall super-replication. Even without considering transaction costs, hedging by using only a subset of underlying assets performs well: only a reasonable small hedging error arises when investing the capital required by the super-hedging portfolio which is composed of plain-vanilla options on all underlying assets and hence is difficult to implement or even not available in the market.
Subjects:Basket options
Principal Components Analysis
Super-replication
Expected shortfall
JEL:G13
Document Type:Working Paper
Appears in Collections:Bonn Econ Discussion Papers, Bonn Graduate School of Economics (BGSE), Universität Bonn

Files in This Item:
File Description SizeFormat
bgse14_2006.pdf405.76 kBAdobe PDF
No. of Downloads: Counter Stats
Download bibliographical data as: BibTeX
Share on:http://hdl.handle.net/10419/22959

Items in EconStor are protected by copyright, with all rights reserved, unless otherwise indicated.