Power options: hedging nonlinear risks

Robert G. Tompkins

Abstract

ABSTRACT

This paper examines contingent claims where the terminal payoff is defined by a curved function and considers the case of squared power options. These products have been repackaged as continuous strike price options, where the strike price of a European option is softened to reduce nonlinear risk at expiration. Other applications include the ability to hedge future levels of implied volatility and to address a number of other nonlinear risks facing risk managers. The author considers the pricing and hedging of squared power options and shows that either a standard dynamic or a simple static approach with European options can effectively hedge these instruments.