The hedging part (although replication is a perfect hedging strategy )is

very tricky.
The usual sensitivities (∆,Γ and ν (vega)are not the same).

A thorough understanding of the risks components is therefore needed.

(There are obviously many more factors than the usual greeks when volatility
smile is included).

In most (if not all)of the exotic products cases, we cannot fully hedge
them in case of a volatility smile, but we instead try to cover some of the
most important risks by using principal component analysis, factor-analysis
or level-slope-curvature type factors (similar to Nelson-Siegel models in in-
terest rates) for the volatility smiles, surface and volatility term-structures.

In the case of PCA for instance, we would have to track the changes
in market prices of options (expressed usually in % changes), make the co-
variance matrix of changes and select these factors that display the highest
variance (through eigen-decomposition and incremental risk factoring).

This is designed to be detailed in a further paper.

3.5 Q3: Sensitivities.

Once identified the main risk factors from Q2, through the methods men-
tioned there (such as PCA), we build scenarios of changes in the principal
factors, and decide depending on the results, what should be hedged.
For instance, if the level-factor of asset prices proves to be essential, we
should construct a ∆-hedge (stock options, or plain-vanilla options). If the
curvature proves to explain better the variance in market price changes, a Γ-
hedge should be used, (a portfolio of options with zero cost but with positive
or negative gamma, same maturities and identical or similar strikes should
be tried), and if curvature of the smile is to be offset, we should try option
spreads in order to do that (combinations of options with different strike
prices but the same maturities).

If volatility term structure however is seen as a risk factor, calendar

spreads should be used.

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