Option pricing and hedging in the presence of cross-hedge risk
Dynamic hedging as an option is a possibility when the underlying asset is not available for trading and some other asset or portfolio is used as a substitute, although this may not always happen.
In recent research1 drawn from the “Structured Products and Derivative Instruments” research chair at Edhec-Risk Institute sponsored by the French Banking Federation (FBF), we addressed the question of option pricing and hedging when the underlying asset is not available for dynamic trading, and some other asset is used as a substitute.
We first provided an overview of the various hedging methodologies that can be used in this incomplete market setting, distinguishing between self-financing and
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