Hedging derivative securities with volatility futures
We show a method to replicate S&P 500 exchange traded fund (ETF) European synthetic put by optimally rebalancing a portfolio of the underlying ETF shares, the VIX futures contracts, and treasury bonds over discrete periods. The motivation for this study is two-fold. Firstly, market-makers in S&P 500 index options may need to hedge a large short position synthetically when the puts are in short supply. Secondly, for an institutional investor holding a large diversified portfolio of US stocks, constructing a long position in synthetic puts is tantamount to providing portfolio insurance. The put replication is useful as the alternative of buying US puts can be prohibitively expensive in a distressed market. The numerical method of Gauss-Hermite quadrature is employed in the optimal solution. Both simulations and empirical validation using historical S&P 500 index ETF and VIX futures price data show effectiveness in the put pricing versus more traditional methods.
optimal replication, dynamic portfolio, stochastic volatility, hedging, derivative securities, volatility futures, derivatives, Gauss-Hermite quadrature, simulation, put replication
Finance and Financial Management | Portfolio and Security Analysis
Finance; Quantitative Finance
International Journal of Financial Markets and Derivatives
YAP, Kian Leong Nelson; LIM, Kian Guan; and ZHAO, Yibao.
Hedging derivative securities with volatility futures. (2016). International Journal of Financial Markets and Derivatives. 5, (2-4), 111-127. Research Collection Lee Kong Chian School Of Business.
Available at: http://ink.library.smu.edu.sg/lkcsb_research/5266
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