Journal of Risk Model Validation

Risk.net

Does hedging with implied volatility factors improve the hedging efficiency of barrier options?

Szymon Borak, Matthias R. Fengler and Wolfgang K. Härdle

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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