Quantitative Finance

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Assessing the effectiveness of local and global

quadratic hedging under GARCH models

Maciej Augustyniak, Frédéric Godin & Clarence Simard

To cite this article: Maciej Augustyniak, Frédéric Godin & Clarence Simard (2017) Assessing
the effectiveness of local and global quadratic hedging under GARCH models, Quantitative
Finance, 17:9, 1305-1318, DOI: 10.1080/14697688.2017.1279342

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Published online: 21 Mar 2017.

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Quantitative Finance, 2017
Vol. 17, No. 9, 1305–1318, https://doi.org/10.1080/14697688.2017.1279342

© 2017 iStockphoto LP

Assessing the effectiveness of local and global

quadratic hedging under GARCH models
MACIEJ AUGUSTYNIAK∗ †‡ and FRÉDÉRIC GODIN§¶ and CLARENCE SIMARD
†Département de mathématiques et de statistique, Université de Montréal, PO Box 6128 Station Centre-ville, Montreal,
Quebec, H3C 3J7, Canada
‡Quantact Actuarial and Financial Mathematics Laboratory, Centre de recherches mathématiques, Université de Montréal, PO
Box 6128, Station Centre-ville, Montreal, Quebec, H3C 3J7, Canada
§Department of Mathematics & Statistics, Concordia University, 1455 De Maisonneuve Blvd. W., Montreal, Quebec, H3G
1M8, Canada
¶École d’actuariat, Université Laval, 2425 rue de l’Agriculture, Quebec City, Quebec, G1V 0A6, Canada
Département de mathématiques, Université du Québec à Montréal, PO Box 8888, Station Centre-ville, Montreal, Quebec,
H3C 3P8, Canada

(Received 14 June 2016; accepted 30 December 2016; published online 21 March 2017)

1. Introduction idea is simple to understand in a discrete time setting (see e.g.

Groundbreaking work in financial theory due in great part to
Fischer Black, Robert Merton and Myron Scholes showed that
it is theoretically possible to completely hedge away the risk
of any derivative position under a certain set of assumptions
by dynamically trading in risky and riskless assets. This ap-
proach to hedging is known as delta hedging and is based on
the paradigm of market completeness and perfect replication.
Unfortunately, due to the impossibility of trading in contin-
uous time, to sudden price jumps, to market frictions and to
the limited availability (or illiquidity) of traded assets, perfect
replication is generally not feasible in a realistic setting.
Local risk-minimization was proposed by Schweizer (1988)
and Schweizer (1991) as a way to approach the hedging prob-
lem more effectively in incomplete markets. The underlying
∗ Corresponding author. Email: augusty@dms.umontreal.ca
© 2017 Informa UK Limited, trading as Taylor & Francis Group
Föllmer and Schweizer 1989) since the objective is to find po-
sitions in the risky and riskless assets such that the incremental
cost of rebalancing the hedging portfolio at the next time step
is as small as possible in a quadratic sense. An alternative to
this local hedging approach is global risk-minimization. Rather
than controlling incremental hedging costs, global hedging
aims to find a trading strategy that minimizes the expected
value of a penalty function applied to the terminal hedging
error, which corresponds to the deficit between the payoff of
the derivative and the terminal value of the hedging portfolio
net of all capital injections. This problem was first solved in dis-
crete time under a quadratic penalty function†† by Schweizer
(1995), who also pointed out that the local and global hedging
approaches are equivalent under a quadratic criterion when one
††Global risk-minimization under a quadratic penalty function is also
known as variance-optimal hedging and mean–variance hedging.
1306
assumes that discounted asset prices are martingales. However,
in the more realistic semimartingale setting, global hedging
should in general give a smaller terminal hedging error.
To date, many papers building upon the seminal work of
Schweizer (1988), Schweizer (1991) and Schweizer (1995)
have taken a mathematical perspective and investigated gen-
eralizations of the underlying theory. For example, Lamberton
et al. (1998) consider local-risk minimization in the presence
of transaction costs, Motoczyński (2000) studies the existence
of an optimal solution to the global risk-minimization prob-
lem in a multivariate setting in the presence or absence of
transactions costs, Černý and Kallsen (2007) extend the results
of Schweizer (1995) in a general semimartingale setting, and
Biagini and Cretarola (2007) show how to apply local-risk min-
imization in the context of defaultable derivatives. However,
there have been relatively few articles examining the empirical
and practical relevance of local and global risk-minimization
(e.g. Badescu et al. 2014, Godin 2016, Hocquard et al. 2015,
Rémillard et al. 2014).
The objective of this article is to investigate and contrast the
effectiveness of local and global quadratic hedging strategies
under GARCH models, both experimentally and empirically.
By quadratic hedging strategies, we mean local and global
risk-minimization strategies based on a quadratic criterion.
Three reasons justify our focus on GARCH models. First, these
models have become ubiquitous in the econometrics literature
due to their strength in explaining volatility dynamics, and
have also been shown to perform well as option pricing models
(Christoffersen et al. 2010a). Second, GARCH models can be
estimated and manipulated with greater ease than continuous
time stochastic volatility jump-diffusion models. Third, it al-
lows us to expand on the works of Badescu et al. (2014), Ortega
(2012) and Rémillard and Rubenthaler (2013) who were the
first authors to address GARCH-based quadratic hedging.
In particular, Rémillard and Rubenthaler (2013) discuss
global quadratic hedging under the physical probability mea-
sure and illustrate the performance of this strategy under
simulated data from a GARCH model. On the other hand,
Badescu et al. (2014) and Ortega (2012) discuss local quadratic
hedging and implement it under a risk-neutral measure using
Monte Carlo simulations. Badescu et al. (2014) also conduct
an extensive empirical experiment and conclude that GARCH-
based local quadratic hedging outperforms a popular Black–
Scholes delta hedging benchmark that makes use of implied
volatilities.
Although these articles discuss local or global quadratic
hedging in the context of GARCH models, the following prac-
tical questions remain: (i) what is the value added that global
quadratic hedging can provide over local quadratic hedging,
(ii) how does the choice of measure (physical or risk-neutral)
impact the effectiveness of quadratic hedging strategies and
(iii) how is the effectiveness of quadratic hedging impacted
by model risk? The main contribution of our article lies in
providing some insight into these three questions.
Our analysis starts off with an experiment based on sim-
ulated data in which we assume that the hedging and data-
generating models coincide. This allows us to understand the
differences between local and global quadratic hedging in a
theoretical setting. We then conduct a model risk experiment
to evaluate how the effectiveness of GARCH-based quadratic
Feature
hedging is impacted by model mis-specification. In this con-
text, we assume that the hedger constructs the hedging portfo-
lio using a Gaussian GARCH model, but the data-generating
model is either a non-Gaussian GARCH, a non-Gaussian expo-
nential GARCH (EGARCH) or a regime-switching GARCH
(RS-GARCH) model. Our study concludes with an empirical
experiment based on S&P 500 data where we evaluate the
effectiveness of GARCH-based hedging, and compare it to
popular delta hedging benchmarks. In particular, we examine
hedging effectiveness during and after the stock market crash
of 2008–2009.
Our analysis assumes that a short position in a standard
European call option is hedged with different moneyness levels
and times to maturity ranging from three months to three years.
Although we restrict our attention to call options, our results
also directly apply to put options. This is due to the fact that
a put option payoff can be expressed as the sum of a call
option payoff and an attainable claim, which can be perfectly
replicated with a static hedge. Overall, we find that global
quadratic hedging can significantly reduce the risk of hedging
vanilla options with long-term maturities (one year or more).
In particular, the performance of this strategy stands out at a
3-year maturity when compared to local quadratic hedging. Its
use should therefore be advocated when hedging Long-Term
Equity AnticiPation Securities (LEAPS), which are actively
traded call and put options on the Chicago Board Options
Exchange that expire two to three years from their issuance.
Moreover, we find that for global quadratic hedging to achieve
its full potential at long-term maturities, it must be imple-
mented under the physical probability measure. In contrast,
we observe that implementing local quadratic hedging with a
mean-correcting risk-neutral measure instead of the physical
probability measure does not decrease hedging effectiveness
at all maturities.
The paper is structured as follows. Section 2 introduces the
notation and explains how to implement local and
global quadratic hedging for a general class of GARCH mod-
els by way of dynamic programming. Section 3 presents the
results of our quadratic hedging analysis. Section 4
concludes.
2. Quadratic hedging
2.1. Definition of the financial market
We consider a frictionless and arbitrage-free financial market
where a risky asset (stock) and a risk-free asset (bond) are
traded. We assume that trading occurs in discrete time over
a fixed financial horizon T ∈ N at equally-spaced times in
the set T := {t | t = 0, 1, . . . , T }. The stock price fol-
lows a square-integrable stochastic process {St }t∈T defined
on a probability space (, FT , P) and adapted to a filtration,
F := {Ft }t∈T , where Ft := σ (S0 , . . . , St ) represents an
information set containing observed market prices up to and
including time t. The bond price follows a deterministic process
{Bt }t∈T that is assumed to grow at the constant one-period
risk-free rate r from an initial value of one: Bt = exp(r t).
The measure P denotes the physical (real-world, objective)
probability measure.
 Feature 1307

2.2. Terminology This deficit is called the terminal hedging error and can be
equivalently expressed as
Definition 1 (Trading strategy) A trading strategy is a pair  
of stochastic processes θ := (θ (B) , θ (S) ) such that θ (B) := T = H − BT V0θ + G θT , (1)
(B) (S)
{θt }t∈T is an adapted process and θ (S) := {θt+1 }t∈T is a which shows that T does not depend on the positions in the
(B)
predictable process. The Ft -measurable random variables θt bond asset for all t ∈ T \ {0}.
(S)
and θt+1 represent, respectively, the number of bond asset Local and global quadratic hedging approaches offer two
shares and the number of shares of stock held over the time different ways to minimize the deviations of T from zero.
period [t, t + 1). On the one hand, global quadratic hedging aims to find a self-
financing hedging strategy θ and an initial capital V0θ that solve
Definition 2 (Value of hedging portfolio) Let Vtθ denote the
value of a hedging portfolio at time t (after rebalancing) based
arg min E 2T . (2)
on the trading strategy θ . For t ∈ T , we have
(V0θ ,θ )
(B) (S)
 
Vtθ := θt Bt + θt+1 St . Note that T = H − VTθ and θt(B) = θt−1
(B) (S) (S)
− θt+1 − θt
(S) (S)
We assume θT +1 = θT , that is, the stock position is not Bt−1 St , t = 1, . . . , T , for a self-financing strategy.
adjusted at time T . On the other hand, local quadratic hedging works with strate-
(B)
gies that are not necessarily self-financing by allowing θt to
Definition 3 (Gains process) Let G θt denote the discounted be freely determined at each time t ∈ T , and imposes VTθ =
hedging gain from time 0 to t, based on the trading strategy θ , T  θ θ

H . In this case, we obtain T = BT t=1 Ct − Ct−1 .
and set G θ0 := 0. For t ∈ T \ {0}, we have Locally risk-minimizing strategies are computed through a
  series of local optimizations having for objective to minimize

t
−1
G θt := θn(S) Bn−1 Sn − Bn−1 Sn−1 . the expected squared incremental hedging costs at each trading
n=1 period. More precisely, starting from t = T, T − 1, . . . , 1,
(B) (S)
the aim is to find the positions (θt−1 , θt ) at time t − 1 that
Definition 4 (Cost process) The discounted hedging cost from  θ θ
2
time 0 to t is defined by Ctθ := Bt−1 Vtθ − G θt , with C0θ = V0θ . minimize E[ Ct − Ct−1 | Ft−1 ], under the constraint that
θ (B) (S)
Vt is constructed from the positions (θt , θt+1 ) that satisfy
Definition 5 (Incremental cost process) The incremental dis- this optimality criterion at time t (for t = T , VTθ = H is im-
θ . Since
counted hedging cost at time t is defined as Ctθ − Ct−1 posed). It can be shown that although locally risk-minimizing
−1 θ (S) strategies are not generally self-financing, they are nevertheless
Ctθ − Ct−1
θ
= Bt−1 Vtθ − Bt−1 Vt−1 − θt
  mean-self-financing, so that the resulting cost process is a P-
−1
× Bt−1 St − Bt−1 St−1 martingale.
   
(B) (B) (S) (S)
= θt − θt−1 + θt+1 − θt Bt−1 St , Remark 1 The statement of the local risk-minimization prob-
lem presented here differs from the original definition given
it corresponds to the total outlay needed at time t (in discounted by Schweizer (1988). However, it is nevertheless equivalent to
terms) to rebalance the hedging portfolio. it as explained by Schweizer (2001, pp. 550–552).
Definition 6 (Self-financing hedging strategy) A trading strat- Remark 2 The trading strategies considered in the local and
egy θ is called self-financing if its cost process is constant, that global quadratic hedging problems must satisfy some square-
is Ctθ = V0θ for all t ∈ T . integrability
 conditions. Itis generally sufficient to assume that
(S)
θt Bt−1 St − Bt−1
−1
St−1 ∈ L2 (P) for t ∈ T \ {0}, and Vtθ ∈
Definition 7 (Mean-self-financing hedging strategy) Atrading
strategy θ is called mean-self-financing if its cost process is a L2 (P) for t ∈ T . See Lamberton et al. (1998) and Schweizer
P-martingale. (1995) for more details.

2.4. Local quadratic hedging algorithm

2.3. Hedging problem
We study the problem of an agent who has entered into a
short position on a European contingent claim with payoff at
time T given by an FT -measurable square-integrable random
variable H . The agent’s objective is to establish a trading
strategy such that the value of its portfolio at time T , net
of all capital injections, will be close to H . A natural way
to assess the attainment of this objective is to compute the
deficit between the claim’s payoff and the terminal value of
the hedging portfolio net of incremental costs, that is,
 
T
 θ  (1998), and thus differs slightly from the one given in Schweizer
θ θ
T := H − VT − BT Ct − Ct−1 .
t=1
The local risk-minimization problem can be solved with the
following backward recursive scheme for t = T, T − 1, . . . , 1
initiated with VTθ = H (see Lamberton et al. 1998, proposi-
tion 2, for more details):†
(1) Compute
(S) Cov e−r Vtθ , t | Ft−1
θt = ,
Var [t | Ft−1 ]
†Note that our definition of the value of the hedging portfolio at time t
(see definition 2) corresponds to the one adopted by Lamberton et al.
(1988). However, both definitions lead to equivalent solutions as
shown by Lamberton et al.(1998, section 4.1).
1308 Feature
(S)
where t := St e−r − St−1 . This value of θt min- νt := E[(1 − t bt /at )νt+1 | Ft−1 ], (14)
imizes e−r E [Ht (1 − t bt /at )νt+1 | Ft−1 ]
  Ht−1 := . (15)
Var Bt−1 Ctθ − Ct−1 θ  Ft−1 νt

(S) 
= Var e−r Vtθ − θt t  Ft−1 . Although global quadratic hedging gives rise to a problem
that may seem more difficult to solve computationally than
(2) Determine Vt−1θ based on the mean-self-financing local risk-minimization, the additional numerical burden is
property of the hedging strategy: in fact relatively small in a discrete time setting (Černý and
 Kallsen 2009).
θ (S) 
Vt−1 = E e−r Vtθ − θt t  Ft−1 ,
Remark 3 When applied under a risk-neutral measure, the
(B) −1 θ (S)
and set θt−1 = Bt−1 (Vt−1 − θt St−1 ). backward recursive schemes in algorithms 1 and 2 are equiva-
lent, in the sense that they yield the same positions in the stock
Note that the terminal condition VTθ = H can always be asset and the same initial value V0θ . This follows from the fact
(B) (S)
satisfied by setting θT = BT−1 (H − θT ST ). that when Bt−1 St is a martingale, we have ∀t, āt = at , b̄t =
The backward recursive scheme presented above can be bt = 0, d̄t = dt , ᾱt = αt and H̄t = Ht . Although solving the
efficiently implemented with the dynamic program set up in underlying optimization problems under a risk-neutral measure
algorithm 1 (see Coleman et al. 2006, for an alternative dy- leads to a simpler solution from a computational standpoint,
namic program). there is no guarantee that the resulting risk-minimizing strategy
Algorithm 1 (Local quadratic hedging dynamic will be close to optimal for minimizing E 2T under P (what
program) Set H̄T = H . For t = T, T −1, . . . , 1, the solution really matters in the end).
to the local quadratic hedging problem is given by:
(S)
θt = ᾱt ,
(B) −1  
θt−1 = Bt−1 H̄t−1 − ᾱt St−1 , 2.6. Implementation under GARCH models
where Many popular GARCH models considered in the econometrics
and option pricing literature can be written as special cases of
āt := E 2t | Ft−1 , (3)
the following GARCH(1, 1) class of models.
b̄t := E [t | Ft−1 ] , (4)
Definition 8 (GARCH(1, 1) class of models) The GARCH
−r
c̄t := e E H̄t | Ft−1 , (5) class models the log-return yt := log(St ) − log(St−1 ), con-
d̄t := e−r E H̄t t | Ft−1 , (6) ditionally on Ft−1 , as
d̄t − b̄t c̄t yt = μt + σt t ,
ᾱt = , (7)
āt − b̄t2
where μt := E[yt | Ft−1 ] represents the conditional mean
H̄t−1 = c̄t − ᾱt b̄t . (8) of yt , σt2 := Var[yt | Ft−1 ] represents the conditional vari-
ance of yt , and t is an innovation independent of Ft−1 with
zero mean and unit variance. The GARCH(1, 1) class that
2.5. Global quadratic hedging algorithm we consider further assumes that this innovation has finite
exponential moments E[exp(σ t )] < ∞, ∀σ > 0, and that
The theoretical solution to the global quadratic hedging prob-
μt = g(σt ) and σt = h( t−1 , σt−1 ), where g(·) and h(·)
lem defined in equation (2) is given by Schweizer (1995).
are parametric functions of their arguments constrained as to
Bertsimas et al. (2001) and Černý (2004) show how to imple-
guarantee second-order stationarity of the process {yt }.†
ment this solution efficiently by way of dynamic programming.
Algorithm 2 summarizes the resulting dynamic program. Note Under this GARCH(1, 1) specification (St−1 , σt ) is a bivari-
that Rémillard and Rubenthaler (2013) used such an approach ate Markov process. This Markov property is key to reduce
in the context of GARCH models. the dimensionality of our dynamic programming algorithms,
because it implies that the processes (3)–(8) in algorithm 1 and
Algorithm 2 (Global quadratic hedging dynamic
the processes (10)–(15) in algorithm 2 can all be expressed as
program) The solution to the global quadratic hedging prob-
functions of only (St−1 , σt ). More precisely, with respect to
lem defined in equation (2) is fully determined by V0θ = H0 and
algorithm 2, there exist functions ãt , b̃t , d̃t , α̃t , ν̃t , H̃t−1 , such
the following backward recursive scheme initiated at t = T ,
that
HT = H and νT +1 = 1:
(S) θ
θt = αt − Vt−1 bt /at , (9) †In the context of quadratic hedging, it is generally assumed that
where St is square-integrable (e.g. Schweizer 1995). Accordingly, the
assumptions on the existence of exponential moments and on second-
at := E 2t νt+1 | Ft−1 , (10) order stationarity are included because they ensure that moments
of St are well-defined. However, we note that Gugushvili (2003)
bt := E [t νt+1 | Ft−1 ] , (11) and Melnikov and Nechaev (1999) were able to weaken the square-
−r integrability requirements commonly encountered in the quadratic
dt := e E [Ht t νt+1 | Ft−1 ] , (12)
hedging literature, and remove the nondegeneracy condition of
αt := dt /at , (13) Schweizer (1995).
 Feature 1309

at = ãt (Z t−1 , σt ), bt = b̃t (Z t−1 , σt ), Table 1. Maximum likelihood parameter estimates of the GARCH
model.
dt = d̃t (Z t−1 , σt ), αt = α̃t (Z t−1 , σt ),
νt = ν̃t (Z t−1 , σt ), Ht−1 = H̃t−1 (Z t−1 , σt ), (16) μ ω α γ β

where Z t := log St . Our dynamic program computes these
functions backwards in time for t = T, T − 1, . . . , 1 on a
discretization of the state space of the Markov chain (Z t−1 , σt ).
At every time step, this state space is represented with a two-
dimensional grid built as the Cartesian product of two discrete-
valued sets:
Gt := {Z (t−1,it ) | i t = 1, . . . , It } × {σ (t, jt ) | jt = 1, . . . , Jt }.
The method for selecting the nodes in Gt is analogous to
the procedure described in François et al. (2014). Refer to
appendix 1 for more details on the computation of the functions
in (16).
3. Analysis of quadratic hedging
Our analysis of quadratic hedging under GARCH models starts
off in section 3.3, where we investigate the improvement in
hedging effectiveness that results from using global rather
than local quadratic hedging under simulated data. Then, in
section 3.4 we conduct an empirical experiment with S&P
500 data to assess how much value can GARCH-based global
quadratic hedging add over benchmark hedges. These two
studies are preceded by two sections that, respectively, describe
the specific GARCH hedging model that is considered (section
3.1), and present a GARCH delta hedging benchmark (section
3.2). Our analyses assume that a short position in a European
call option is hedged with different moneyness levels and times
to maturity. More precisely, we consider an initial stock price
of S0 = 100, and the payoff H = max(ST − K , 0), with
strike price K = 90 (in-the-money, ITM), 100 (at-the-money,
ATM), or 110 (out-the-money, OTM) and maturity of T = 60
(3 months), 260 (1 year), or 780 (3 years) days.
3.1. GARCH model
Definition 9 (GARCH model) The model that we will refer to
as GARCH in our analysis is a special case of the GARCH(1, 1)
class of models introduced in definition 8. It includes a Gaus-
sian innovation, a constant conditional mean μ (i.e., μt = μ,
∀t), and models the conditional variance as
σt2 = ω + ασt−1
2
(| t−1 | − γ t−1 )
2
+ βσt−1
2
.
This volatility specification was introduced under a slightly
different, but equivalent, parametrization by Glosten et al.
(1998) and is commonly known as the GJR-GARCH model.
3.1.1. Measure P. The P-dynamics of the GARCH model
were estimated on a time series of daily percentage log-returns
on the S&P 500 price index for the period 31 December 1986–
4 January 2010 (5863 observations). Table 1 reports maximum
likelihood parameter estimates and associated asymptotic stan-
dard errors. The daily stationary volatility† is 1.061%, which
†The stationary (or unconditional) variance corresponds to
ω risk-minimizing strategy by letting the time between two consecutive
E[σt2 ] = ,
1 − α(1 + γ 2 ) − β
0.0292 0.0179 0.0545 0.591 0.911
(0.0108) (0.0025) (0.0086) (0.103) (0.008)
Notes: These parameter estimates were computed on a time series of daily
percentage log-returns on the S&P 500 price index for the period 31 December
1986–4 January 2010 (5863 observations). Asymptotic standard errors are
given in parentheses.
gives an annualized stationary volatility of 17.1% (based on a
year with 260 business days).
3.1.2. Risk-neutral measure Q. We now introduce a
standard change of measure considered in the GARCH
option pricing literature (e.g. Badescu et al. 2014, Christof-
fersen et al. 2010a, Duan 1995, Ortega 2012) that allows us
to define a specific risk-neutral measure, which we denote by
Q. Simply put, this measure transformation shifts the condi-
tional mean, but keeps the conditional variance unchanged.
Define the conditional mean shift at time t by ηt ∈ Ft−1 ,
and assume that, conditionally on Ft−1 , ˜t := t + ηt is a
Gaussian innovation with zero mean and unit variance under
some measure Q. For measure Q to qualify as a risk-neutral
measure, the expected one-period effective return on the stock
price must correspond to the one-period risk-free rate of return
r , which translates into the following condition (note that yt =
μ − σt ηt + σt ˜t ),
 
exp(r ) = exp μ − σt ηt + σt2 /2 ,
or equivalently,
μ − r + σt2 /2
ηt = .
σt
This conditional mean shift characterizes the measure transfor-
mation and ensures that the discounted stock price process is
a martingale under Q. The Q-dynamics of the GARCH model
can thus be expressed as
yt = r − σt2 /2 + σt ˜t ,
σt2 = ω + ασt−1
2
(|˜t−1 − ηt−1 | − γ (˜t−1 − ηt−1 ))2 + βσt−1
2
.
3.2. Delta hedging benchmark
Delta hedging is implemented in our analysis to serve as a
benchmark. The definition of the call option delta given by
Duan (1995) corresponds to‡:
provided that the denominator is positive.
‡Delta hedging under a GARCH model is somewhat of an ambiguous
concept because this model is incomplete and defined in discrete
time. Different approaches to specify a continuous time limit could, in
principle, lead to different definitions of delta hedging. Accordingly,
Duan (1995)’s definition of the delta was subject to criticism, notably
by Garcia and Renault (1998). Nevertheless, Badescu et al. (2014)
show that this delta appears as a component of an approximate locally
observations approach zero.
1310 Feature
(S) ∂ −r (T −t) Q
θt+1 = e E [max(ST − K , 0) | Ft ]
∂ St  

ST  mean-square error (RMSE), defined as
= e−r (T −t) EQ 1{ST ≥K }  Ft ,
St
where 1 A is the indicator function of set A, K denotes the
option’s strike price and the superscript Q on the expectation
term indicates that the expectation is computed under the risk-
neutral measure Q. Although Duan (1995) evaluated this delta
with Monte Carlo simulations, it is also possible to compute it
(S)
by setting up a dynamic program as follows. Set θt+1 = ξt , and
iterate backwards starting from t = T − 1 and ξT = 1{ST ≥K }
according to equation ξt = e−r EQ [e yt+1 ξt+1 | Ft ].†
3.3. Experiments with simulated data
We start off our analysis by investigating the effectiveness of
GARCH-based quadratic hedging in a setting where there is no
model risk. We simulated N = 10 000 daily stock price paths
with the Gaussian GARCH model under measure P and, on
each one of these paths, we applied local and global quadratic
hedging approaches under measures P and Q. The simulations
were initiated with a stock price of S0 = 100 and a daily sta-
tionary volatility of σ1 = 1.061%. The bond asset is assumed
to grow at an annualized risk-free rate of 2%, which yields a
daily risk-free rate assumption of r = 0.00769%.
To allow for a comparison on equal grounds, the hedging
strategies are all assumed to be initiated with the same capital
for a given option strike price and maturity. The initial capital
is chosen as the optimal capital associated with GARCH-based
global quadratic hedging under P, that is V0θ = H0 (see equa-
tion (15)). Table 2 presents the values of this capital at different
moneyness levels and times to maturity, as well as alternative
choices for V0θ . We observe that the optimal capital obtained
with global quadratic hedging under P is almost identical to the
capital computed under Q. Therefore, the choice between these
two approaches seems irrelevant for determining an initial
capital in our experiment.‡ Moreover, note that our choice of
initial capital does not put any of the hedging strategies at
a disadvantage because the terminal discounted hedging gain
G θT is impacted by V0θ only in the context of global quadratic
hedging under P.
Hedging effectiveness can be assessed by examining the
distribution of the N =10 000 realizations of the terminal
†This equation is obtained as follows:
  
ST 
ξt = e−r (T −t) EQ 1{ST ≥K }  Ft
St
   
ST 
= e E e t+1 e−r (T −(t+1))
−r Q y 1{ST ≥K }  Ft
St+1
    
ST  
= e−r EQ e yt+1 e−r (T −(t+1)) EQ 1{ST ≥K }  Ft+1  Ft
St+1

= e−r EQ e yt+1 ξt+1  Ft .
‡For a comparison of option prices under different pricing measures,
including measures related to the local and global quadratic hedging
problems in continuous time, see Henderson and Hobson (2003),
Henderson (2005) and Henderson et al. (2005).
hedging error T (see equation (1)); the realization of T on
path i is denoted by T,i . In particular, we consider the root-


1  N
RMSE =  2T,i ,
N
i=1
and the 95% Value at Risk (VaR), which corresponds to the
501th largest value of {T,i }i=1
10000 . Since global quadratic hedg-
ing minimizes the RMSE by definition, it will of course be the
winner with respect to this criterion. Our goal, however, is to
determine how large the gain actually is and evaluate whether
minimizing this measure also translates into an improvement
with respect to the downside risk of hedging, as measured by
the 95% VaR. Our analysis of the hedging results presented in
table 3 is structured around the following three questions.
• By what margin is global quadratic hedging more effective
than local quadratic hedging?
We observe that the relative improvement in hedging
effectiveness resulting from global quadratic hedging under
P becomes larger when the option’s maturity increases. For
short-term options with a 3-month maturity, global hedging
does not seem to add much value. For medium-term options
with a 1-year maturity, the improvement in the RMSE is of
the order of 5%, which is still modest. However, for a 3-year
maturity, global hedging succeeds at reducing the RMSE by
10–12%, and does even better with respect to the 95% VaR,
which it trims down by 20–31%. This shows that a global
approach to quadratic hedging can also considerably reduce
the downside risk of hedging at long-term maturities. We note
that Heath et al. (2001a) and Heath et al. (2001b) performed a
comparison of local and global quadratic hedging in a contin-
uous time stochastic volatility setting and also found that the
relative performance of the global approach improves when
the option’s maturity increases.
• How does the choice of measure (P or Q) impact the effec-
tiveness of quadratic hedging strategies?
Ortega (2012) claimed that the loss of effectiveness from im-
plementing local quadratic hedging under measure Q instead
of P should be small in the GARCH setting on a daily time
scale.§ Since he did not implement local quadratic hedging
under P, he was unable to verify this claim experimentally. Our
results support his claim as we only observe negligible differ-
ences between statistical measures reported for local quadratic
hedging strategies under P and Q. However, in the context of
global quadratic hedging, this claim is no more true, because
we observe large differences between global quadratic hedging
under P and global/local quadratic hedging under Q for long-
term maturities. Therefore, the choice of measure (P or Q) does
matter for global quadratic hedging.
§Ortega (2012) showed that when the drift term in the GARCH model
is ‘sufficiently small’ the linear Taylor expansions of the locally risk-
minimizing value process in the drift term under measures P and
Q coincide. Based on this result, he asserted that ‘carrying out the
risk-minimizing program with respect to the physical measure or the
equivalent martingale measure …yields virtually the same results’.
 Feature 1311

Table 2. Initial capital V0θ computed for ATM (K = 100), OTM (K = 110) and ITM (K = 90) call options with T = 60, 260 and 780 days
to maturity.

ATM OTM ITM

Days to maturity 60 260 780 60 260 780 60 260 780

GARCH capital under P 3.44 7.83 15.04 0.36 3.45 10.37 10.98 14.42 20.89
GARCH capital under Q 3.44 7.81 15.01 0.36 3.44 10.34 10.98 14.41 20.87
Black–Scholes capital 3.51 7.79 14.58 0.59 3.85 10.28 10.74 13.95 20.14
Notes: GARCH capital under P: Optimal capital associated with GARCH-based global quadratic hedging under P, V0θ = H0 (see equation (15)). GARCH
capital under Q: Risk-neutral expectation of the discounted payoff under the GARCH model and measure Q, V0θ = e−r T EQ [max(ST − K , 0)]. Black–Scholes
capital: Black–Scholes call price based on an annualized risk-free rate assumption of 2% and an annualized volatility parameter of 17.1%, which corresponds
to the stationary annualized volatility of the GARCH model.

Table 3. RMSE and 95% VaR of the terminal hedging error for ATM (K = 100), OTM (K = 110) and ITM (K = 90) call options with
T = 60, 260 and 780 days to maturity.

ATM OTM ITM

Days to maturity 60 260 780 60 260 780 60 260 780

RMSE
Global under P 0.80 1.36 1.73 0.42 1.26 1.85 0.58 1.21 1.52
Local under P 1% 5% 11% 1% 5% 10% 0% 5% 12%
Global/Local under Q 1% 5% 11% 1% 5% 10% 0% 6% 12%
Delta hedging 17% 30% 41% 12% 31% 44% 15% 27% 37%

95% VaR
Global under P 1.43 2.35 2.71 0.75 2.21 2.92 0.91 1.91 2.16
Local under P 3% 5% 22% 1% 5% 20% 4% 12% 31%
Global/Local under Q 2% 7% 23% 1% 7% 22% 4% 13% 32%
Delta hedging 18% 22% 32% −4% 14% 25% 30% 36% 49%
Notes: These statistical measures are computed based on 10 000 realizations of T which depend on 10 000 trajectories generated from the GARCH model
under measure P. The statistical measures associated with global quadratic hedging are expressed in absolute terms (bold font), whereas those associated with
all the other hedging strategies are expressed relative to these values (% increase).

• How does the effectiveness of quadratic hedging strategies
compare to delta hedging?
We observe that delta hedging induces a much greater vari-
ability in the terminal hedging error when compared to
quadratic hedging. For instance, the RMSE associated with
delta hedging is approximately 30% and 40% larger than the
RMSE associated with global quadratic hedging under P for
1 and 3-year maturities, respectively. The global strategy also
adds considerable value over delta hedging with respect to
the downside risk of hedging. However, the same cannot be
said of local quadratic hedging as we observe that this strategy
results in more moderate improvements, especially at 3-year
maturities and for OTM options.
3.3.1. Pathwise criteria. Until now our assessment of hedg-
ing effectiveness was based on the terminal hedging error. Even
though the ultimate goal of hedging is to reduce this error,
day-to-day behaviour of the hedging strategy also matters to
traders in practice (Ahmad and Wilmott 2005). For instance,
for any time t ∈ T , the shortfall between the market value
of the hedged option, denoted by Htmarket , and the value of
the hedging portfolio net of incremental costs should also be
small. More precisely, traders want to avoid large values of the
hedging error,
t := Htmarket − Bt (V0θ + G θt ),
for every time t ∈ T . To assess the performance of each
hedging strategy with respect to this type of criterion, we
computed the maximal hedging error on each simulated path,
that is maxt∈T t , by assuming that Htmarket = e−r (T −t) EQ
[max(ST − K , 0) | Ft ].
Moreover, we also calculated the total turnover in the stock
position, defined as
T  
  (S) (S) 
(S)
θ := θt+1 − θt  . (17)
t=1
Between two similarly effective hedging strategies, traders will
generally prefer the strategy with the lowest θ (S) , because
this strategy implies less adjustments to the stock position and
also implicitly leads to smaller transaction costs.
Results are presented in table 4. For a maturity of three
years, we observe that local quadratic hedging is slightly more
effective at avoiding large hedging shortfalls throughout the
term of the contract (by approximately 5%). This result there-
fore suggests that there is a price to pay inside the hedging
trajectory when the strategy is established solely based on
a terminal hedging error criterion. However, this price does
not seem significant enough to discredit the benefits of global
quadratic hedging shown in table 3. Furthermore, with respect
to the total turnover in the stock position, we do not observe
any significant differences between local and global quadratic
hedging. Delta hedging, on the other hand, does leads to less
1312 Feature

Table 4. Mean of the maximal pathwise hedging error and of the total turnover in the stock position.

ATM OTM ITM

Days to maturity 60 260 780 60 260 780 60 260 780

Maximal pathwise hedging error (average over all paths)

Global under P 0.56 1.06 1.47 0.27 1.00 1.60 0.33 0.87 1.24
Local under P 0% −1% −5% −1% −2% −6% 1% −1% −5%
Global/Local under Q 0% −1% −4% 0% −1% −5% 1% 0% −4%
Delta hedging 11% 11% 3% −2% 2% −2% 22% 20% 8%

Total turnover in the stock position (average over all paths)

Global under P 2.40 4.84 7.73 1.18 4.98 8.79 1.06 3.39 6.11
Local under P 0% −1% −2% −1% −2% −2% 0% −1% −2%
Global/Local under Q 0% −1% −2% −2% −2% −2% 1% 0% −2%
Delta hedging −1% −7% −14% 12% 0% −10% −18% −16% −18%
Notes: These results are based on 10 000 trajectories generated from the GARCH model under measure P. ATM (K = 100), OTM (K = 110) and ITM
(K = 90) call options are considered with T = 60, 260 and 780 days to maturity. The maximal pathwise hedging error is defined as maxt∈T t , whereas the
total turnover in the stock position is defined in equation (17). The values associated with global quadratic hedging are expressed in absolute terms (bold font),
whereas those associated with all the other hedging strategies are expressed relative to these values (% increase).

adjustments in the stock position across all moneyness levels (9)), which entails that this strategy has the ability to correct
for a 3-year maturity. itself when model error generates unanticipated changes in the
value of the hedging portfolio.

3.3.2. Robustness to model risk. We now digress from the

idealized setting considered previously, and introduce model
3.3.3. Applicability of results to other payoffs. Although
risk. The rationale is simple; in the real world it is impossi-
our previous analyses were restricted to call option payoffs,
ble to pick the right hedging model. Therefore, it is of high
all of our results also apply to put option payoffs. This is due
practical importance to determine the extent to which the ef-
to put-call parity, which shows that a put option payoff can be
fectiveness of quadratic hedging can be impacted by model
expressed in terms of the payoffs of a call option and a forward
mis-specification. To investigate this impact, we repeat the
contract. As a result, the hedging error t for both options is
experiment of table 3, but we now assume that daily stock price
equal with probability one for all t ∈ T on any given stock
paths are simulated with one of the following three models
price path.
(hedging is still performed with the Gaussian GARCH model
Since our results show that global quadratic hedging adds
under measures P and Q): (1) GARCH model with a general-
value for long-dated vanilla options, such as LEAPS, this strat-
ized error distribution (GED) innovation, (2) EGARCH model
egy should also prove beneficial when hedging vanilla market-
with a GED innovation and (3) RS-GARCH model with two
linked certificates of deposit (CDs), which are structured
regimes.† The GED was considered by Nelson (1991) in the
products offering embedded call option payoffs with a typi-
context of the EGARCH model to allow for an innovation
cal term of three to five years. These types of products can
distribution with thicker tails than the normal. These three
generally be decomposed into a zero-coupon bond and vanilla
models are estimated on the same data set as our Gaussian
options (see Deng et al. 2013, section 4.4, for an overview).
GARCH model. Refer to appendix 2 for more details.
However, the value added of global quadratic hedging is not
Table 5 presents the results of our model risk experiment
necessarily identical for all types of payoffs. For example,
for an ATM call option with T = 60, 260 and 780 days
table 6 repeats the experiment of table 3 for a digital option
to maturity. Since results for OTM and ITM options lead to
(also known as a binary or cash-or-nothing option) with payoff
similar observations, they are not reported. We observe that the
H = 1001{ST ≥K } , where K = 90, 100 and 110. We observe
general conclusions reached in the idealized setting of table 3
that the benefits of global quadratic hedging are much more
continue to hold true, but the dominance of global quadratic
modest in this context. For instance, at a 3-year maturity the
hedging is even more significant in the presence of model risk.
improvement of global versus local quadratic hedging is of 2–
This result suggests that global quadratic is more robust to
4% with respect to the RMSE (compared to 10–12% for a call
model risk than local risk-minimization. This can be explained
option) and of 1–5% with respect to the 95% VaR (compared
on the basis that the stock position in the global strategy is a
to 20–31% for a call option). Moreover, although quadratic
function of the value of the hedging portfolio (see equation
hedging significantly improves over delta hedging with respect
to the RMSE, this advantage does not translate to the 95%
†Note that in this experiment we assume that the stock price process VaR. The difference in results may be due to the discontin-
is generated from a physical probability measure that is distinct from uous nature of the digital option payoff. This type of payoff
P (and Q). The hedging strategy is therefore constructed based on a
mis-specified Gaussian GARCH model. For an alternative way to is difficult to hedge dynamically because small moves in the
assess the robustness of quadratic hedging to model risk, see Di Nunno underlying around the strike price can have very large effects
et al. (2015). on the option’s value. Further research is therefore warranted to
 Feature 1313

Table 5. RMSE and 95% VaR of the terminal hedging error for ATM (K = 100) call options with T = 60, 260 and 780 days to maturity.

GARCH-GED EGARCH-GED RS-GARCH

Days to maturity 60 260 780 60 260 780 60 260 780

RMSE
Global under P 0.95 1.57 1.82 0.84 1.28 1.25 0.76 1.28 1.61
Local under P 3% 13% 30% 2% 12% 34% 2% 7% 16%
Global/Local under Q 3% 13% 30% 2% 12% 34% 2% 7% 16%
Delta hedging 15% 33% 58% 17% 37% 76% 17% 32% 52%

95% VaR
Global under P 1.64 2.59 2.33 1.62 2.64 2.21 1.29 1.85 1.76
Local under P 3% 18% 61% 2% 8% 41% 2% 14% 30%
Global/Local under Q 4% 18% 63% 2% 10% 43% 3% 15% 33%
Delta hedging 11% 16% 42% 13% 16% 35% 20% 27% 38%
Notes: These statistical measures are computed based on 10 000 realizations of T which depend on 10 000 trajectories generated from different data-generating
models (see appendix 2 for model definitions and parameters). The statistical measures associated with global quadratic hedging are expressed in absolute
terms (bold font), whereas those associated with all the other hedging strategies are expressed relative to these values (% increase).

Table 6. RMSE and 95% VaR of the terminal hedging error for ATM (K = 100), OTM (K = 110) and ITM (K = 90) digital options with
T = 60, 260 and 780 days to maturity.

ATM OTM ITM

Days to maturity 60 260 780 60 260 780 60 260 780

RMSE
Global under P 15.6 11.3 8.8 12.4 12.7 9.4 9.7 9.2 7.7
Local under P 0% 1% 3% 0% 1% 2% 0% 2% 4%
Global/Local under Q 0% 1% 4% 0% 2% 6% 0% 2% 6%
Delta hedging 4% 9% 18% 6% 8% 18% 7% 14% 19%

95% VaR
Global under P 23.9 15.9 11.0 19.7 19.2 12.4 10.9 11.2 9.2
Local under P −2% −2% 1% 0% 1% 2% −1% 1% 5%
Global/Local under Q 0% 0% 3% 1% 3% 2% 1% 2% 6%
Delta hedging −10% −10% −4% −9% −8% −8% −21% −8% 8%
Notes: These statistical measures are computed based on 10 000 realizations of T which depend on 10 000 trajectories generated from the GARCH model
under measure P. The statistical measures associated with global quadratic hedging are expressed in absolute terms (bold font), whereas those associated with
all the other hedging strategies are expressed relative to these values (% increase).

investigate how the payoff structure impacts the effectiveness paths are not all independent. For simplicity, we continue to
of quadratic hedging. assume a constant daily risk-free rate of r = 0.00769% (2%
annualized). Figure 1 illustrates important characteristics of
the empirical data set that we consider.

3.4. Empirical test

In this section, we move away from evaluating hedging per-
formance on simulated data and assess the effectiveness of
GARCH-based quadratic hedging on empirically observed re-
turn paths of the S&P 500 price index. We consider T = 60, 260
and 780-day call option contracts issued on every business day
between 4 January 2008 and 30 March 2012. The stock price
path associated with each one of these contracts is assumed to
start at S0 = 100 and then to mimic the returns on the S&P
500 price index during the term of the contract. For example,
the 780-day contract issued on 4 January 2008 is exposed
to S&P 500 return data from 4 February 2008–4 May 2011
inclusively whereas the 780-day contract issued on 30 March
2012 is exposed to S&P 500 return data from 4 February 2012–
8 May 2015 inclusively. In total, we obtain 1 010 stock price
paths. It must be noted that since these paths are based on series
of overlapping returns, the hedging errors computed on these
3.4.1. Hedging strategies. On each stock price path, we
compute the terminal hedging error for ATM (K = 100), OTM
(K = 110) and ITM (K = 90) call options with the GARCH-
based hedging strategies considered in previous sections (re-
sults for local quadratic hedging under P are not shown because
they are essentially identical to those for global/local quadratic
hedging under Q). Note that since we implement these strate-
gies with the GARCH model presented in table 1, which was
estimated on S&P 500 data from 31 December 1986–4 January
2010, option contracts issued between 1 April 2008 and 31
March 2010 are not fully out-of-sample in our experiment.
However, we prefer to include contracts issued before the stock
market crash of 2008–2009 as this allows us to test hedging
effectiveness in an environment where volatility explodes and
where the underlying asset is exposed to significant market
swings. Moreover, the parameters of our GARCH model are
1314 Feature

140
120
Stock

100
80
60

2009 2010 2011 2012 2013 2014 2015

10
Returns

−5

−10
2009 2010 2011 2012 2013 2014 2015

80
GARCH

60

40

20

2009 2010 2011 2012 2013 2014 2015

Figure 1. Characteristics of S&P 500 data for the time period 1 April 2008–8 May 2015. Top: Stock price path assuming an index value of
100 on 1 April 2008. Middle: S&P 500 price returns (in %). Bottom: Daily volatility (in %) computed from the GARCH model with parameters
in table 1 (shown on an annualized basis).

Table 7. RMSE and 95% VaR of the terminal hedging error for ATM (K = 100), OTM (K = 110) and ITM (K = 90) call options with
T = 60, 260 and 780 days to maturity.

ATM OTM ITM

Days to maturity 60 260 780 60 260 780 60 260 780

RMSE
Global GARCH under P 1.75 2.13 1.49 1.02 1.68 1.39 1.79 2.23 1.41
Global/Local GARCH under Q 1.57 2.26 2.62 0.92 1.85 2.51 1.61 2.33 2.55
GARCH delta hedging 1.99 3.29 3.11 1.07 2.66 3.06 2.05 3.43 2.77
Local Heston 1.41 2.39 2.70 0.72 1.82 2.47 1.71 2.68 2.85
Black–Scholes delta hedging 1.41 3.41 2.43 1.22 2.90 2.67 2.12 3.48 2.43

95% VaR
Global GARCH under P 4.30 5.34 4.02 1.56 3.83 2.62 4.44 6.13 3.98
Global/Local GARCH under Q 4.03 5.49 6.33 1.58 4.28 4.75 4.04 5.75 6.42
GARCH delta hedging 5.39 8.73 8.32 1.71 6.74 7.03 4.80 9.36 7.08
Local Heston 3.40 5.79 7.26 1.14 4.07 5.13 4.78 6.85 7.92
Black–Scholes delta hedging 3.50 8.28 3.47 1.30 7.12 3.09 5.71 8.32 4.15
Notes: These statistical measures are based on 1 010 values of T computed from empirically observed return paths of the S&P 500 price index starting on
every business day between 1 April 2008 and 30 March 2012. The lowest statistical measure for each moneyness and maturity is indicated in bold font.

little affected when the final two years of the estimation period
are removed.†
To put the results of GARCH-based hedging strategies in
perspective, we also compute the terminal hedging error with
two benchmarks that are unrelated to GARCH models. The
first benchmark is a standard Black–Scholes delta hedge with
a volatility parameter that is dynamically calibrated to the
†The maximum likelihood parameter estimates of the GARCH model
based on the S&P 500 price index for the period 31 December 1986–1
April 2008 are: μ = 0.0304, ω = 0.0184, α = 0.0560, γ = 0.560
and β = 0.909. These estimates are very close to the ones provided
in table 1.
realized S&P 500 volatility on a rolling window of one year
(based on daily returns). The second benchmark consists of the
locally risk-minimizing delta hedge under the stochastic volatil-
ity model of Heston (1993), as presented by Poulsen et al.
(2009).† The parameters that we consider for this model are
†This delta hedge is computed under the minimal equivalent
martingale measure in Heston’s model, which is known explicitly, and
thus corresponds to the locally risk-minimizing delta hedge under the
physical probability measure of this model. Although this delta hedge
has the advantage of being available in semi-closed-form, it requires
us to infer the unobserved instantaneous variance in Heston’s model.
To infer this variance, we use a particle filtering algorithm constructed
 Feature
Global GARCH Local GARCH
ATM
2009 2010
Global GARCH Local GARCH
OTM
2009 2010
Global GARCH Local GARCH
ITM
2009 2010
Figure 2. Evolution of the terminal hedging error for S&P 500 call options with T = 780 days to maturity issued on every business day
between 1 April 2008 and 30 March 2012. The horizontal axis specifies the option’s issue date. Top: ATM call option (K = 100), Middle:
OTM call option (K = 110), Bottom: ITM call option (K = 90).
based on those of model SV in Kaeck and Alexander (2013,
table 6) (the S&P 500 data period used by these authors to
estimate this model is the same as the one we consider to fit
our GARCH model).
3.4.2. Initial capital. One should note that the initial capital
used to compute the global quadratic hedging strategy does not
necessarily need to correspond to the actual payment received
by the option writer. Suppose for example that the market is
illiquid, and that call option contracts are sold at a significant
premium. It would then not be sensible to want that a self-
financing strategy initiated from the option’s sale price be
as close as possible to the call option payoff at maturity. In
fact, we would expect that the terminal value of this strat-
egy be larger than this payoff on average. This suggests that
the global quadratic hedging criterion is most appropriate for
self-financing hedging strategies that are started with a good
approximation of the amount of money required to replicate
the option’s payoff. Therefore, a distinction needs to be made
between the actual cash amount received by the option writer
and the value of V0θ that is used to compute the global quadratic
hedging strategy. For this reason, we will not base V0θ on
option prices that were actually observed during the time pe-
riod considered in our empirical test. However, to compare all
similarly to the one proposed by Christoffersen et al. (2010b, section
3). The particle filtering algorithm is applied on a discretized form of
Heston’s model. It aims to approximate the conditional distribution
of the instantaneous variance given the observed data (known as the
filtering distribution) sequentially in time with a discrete distribution
whose support points are called particles.
1315
Local Heston GARCH delta Black−Scholes delta 10
5
−5
2011 2012
Local Heston GARCH delta Black−Scholes delta 10
5
−5
2011 2012
Local Heston GARCH delta Black−Scholes delta 10
5
−5
2011 2012
hedging strategies on equal grounds, we still need to assume a
common initial capital. As in previous sections, we select V0θ
as the optimal capital associated with GARCH-based global
quadratic hedging under P. Because this capital is a function of
the GARCH volatility at the time the option contract is issued,
V0θ varies in time in our empirical test.
3.4.3. Results. Table 7 presents the results of our empiri-
cal test. We observe that the performance of global quadratic
hedging under P stands out from all other strategies at 1 and
3-year maturities. In fact, at these maturities, it is always the
most effective hedging strategy with respect to the RMSE, and
whenever it is not the winner with respect to the 95% VaR,
it is a close second. Moreover, the improvement in hedging
effectiveness is far from being marginal as it is not uncom-
mon to observe a 30–50% risk reduction relative to competing
strategies. However, the dominance of global quadratic hedg-
ing fades when it is implemented under the Q measure. For
instance, at a 3-year maturity statistical measures associated
with the strategy under Q are 60–80% higher than those under
P. Nevertheless GARCH-based quadratic hedging under Q still
compares reasonably well to Heston’s locally risk-minimizing
delta hedge. These empirical results underscore the importance
of making the right choice of measure to take full advantage
of global quadratic hedging at long-term maturities.
Because the statistical measures in table 7 are computed
based on hedging error outcomes on overlapping paths, we may
gain some additional insight by analysing the evolution in time
of the terminal hedging error. Figure 2 illustrates the evolution
of this error for call options with 780 days to maturity. We first
1316
observe that option contracts issued at the outset of the stock
market crash of 2008–2009 generally led to higher hedging
losses. This is because 3-year contracts issued between July
and November 2008 were actually hit by two highly turbulent
periods: (i) the financial crisis of 2008–2009 at inception of
the option contract, and (ii) a period of severe stock market
volatility near maturity associated with the European sovereign
debt crisis (August to October 2011). Contracts issued before
July 2008 were able to escape the second turbulent period and
thus generally lead to lower hedging errors. After the height of
the financial crisis in early 2009, we observe that the hedging
error is trending downwards. The downward kink in the third
quarter of 2011 is due to the fact that contracts issued after that
time avoided the two turbulent periods mentioned previously,
and were thus not exposed to severe volatility.
Moreover, the two strategies that performed the best at the
onset of the 2008–2009 financial crisis were global quadratic
hedging under P and Black–Scholes delta hedging. However,
Black–Scholes delta hedging was generally inferior to other
strategies during mid-2009 to mid-2010 whereas global
quadratic hedging rarely performed worse than its local coun-
terpart and Heston’s locally risk-minimizing delta hedge.
Despite this, Black–Scholes delta hedging still compares rea-
sonably well with other strategies overall for ATM and OTM
options. Furthermore, note that GARCH delta hedging does
surprisingly well post-crisis and rarely generates a hedging
loss. This can be explained on the basis that this hedge over-
shoots the position in the stock asset when compared to risk-
minimizing hedges.† Since a larger stock position inevitably
leads to additional gains in a rising market, the better per-
formance of the GARCH delta hedge after 2009 was to be
expected in some sense. Of course, there is no free lunch here as
this good performance is overshadowed by a poor performance
associated with contracts issued at the onset of the stock market
crash.
4. Conclusion
This article studied the effectiveness of local and global
quadratic hedging strategies under GARCH models, both ex-
perimentally and empirically. Our analysis addressed three im-
portant practical issues: (i) the value added of global over local
quadratic hedging, (ii) the importance of the choice of mea-
sure (physical or risk-neutral) when implementing quadratic
hedging and (iii) the robustness of quadratic hedging to model
mis-specification.
Overall, we found that global quadratic hedging can signifi-
cantly reduce the risk of hedging vanilla options with long-term
maturities (one year or more). Although differences in hedging
†Unlike risk-minimizing delta hedges, the GARCH delta hedge
ignores that the stock price and its volatility could be related
through a leverage effect. This well-documented stylized fact of
stock market returns entails that negative returns are generally
followed by an increase in volatility. Therefore, when returns are
negative, the call option directly loses value through the stock price
decrease and indirectly gains value through an expected higher future
volatility, resulting in a natural partial hedge. This feature is not taken
into account by the GARCH delta hedge, which explains why it
overhedges the call option with a larger stock position than is needed.
See also Badescu et al. (2014, p. 21) for a mathematical justification
of this observation.
Feature
effectiveness were not large enough to discriminate between
local and global quadratic hedging at short-term maturities,
the performance of the global approach really stood out at
a 3-year maturity. This can be explained on the basis that
the global strategy can adapt and correct itself according to
the hedging error previously incurred, whereas the local strat-
egy is inert in this respect. Our results therefore suggest that
global quadratic hedging should be advocated when hedging
LEAPS and other long-term derivatives with embedded call (or
put) option payoffs, such as vanilla market-linked CDs. More-
over, we found that to take full advantage of global quadratic
hedging at long-term maturities, it is imperative to implement
this strategy under the physical probability measure rather
than a risk-neutral measure. However, we observed that the
choice of measure is rather inconsequential for local quadratic
hedging, and therefore no longer of first-order importance.
Finally, our results indicated that the effectiveness of global
quadratic hedging is robust to model mis-specification.
In future research, it would be interesting to investigate the
performance of quadratic hedging for payoff structures other
than calls or puts. For example, some non-vanilla market-
linked CDs include ratchet features or Asian-type payoffs (see
Deng et al., 2013). Additionally, it would be worthwhile to
compare the effectiveness of GARCH-based quadratic hedging
to global risk-minimization strategies constructed
based on non-quadratic criteria, such as VaR. For instance,
François et al. (2014) developed a flexible methodology for
implementing global risk-minimization under any desired
penalty function within a general regime-switching framework.
Given the ability of regime-switching models to account for
time-variation in parameters, it would also be interesting to
evaluate whether the effectiveness of global risk-minimization
can further be improved based on a RS-GARCH modelling
framework.
Disclosure statement
No potential conflict of interest was reported by the authors.
Funding
Maciej Augustyniak gratefully acknowledges financial support from
the Natural Sciences and Engineering Research Council of Canada
[RGPIN-2015-05066]. Frédéric Godin gratefully acknowledges fi-
nancial support from the Fonds de recherche du Québec – Nature et
technologies [2017-NC-197517].
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Appendix 1. Sketch of the dynamic programming
algorithm
This section explains how to compute ãt . The computations for the
other functions in (16) are analogous. First, note that under our
GARCH(1,1) specification in definition 8, Z t = Z t−1 + g(σt ) + σt t
and σt+1 = h( t , σt ), which allows us to write
ãt (Z t−1 , σt ) = E 2t νt+1 | Ft−1
= E 2t ν̃t+1 (Z t , σt+1 ) | (Z t−1 , σt )
 
= E t t , Z t−1 , σt | (Z t−1 , σt ) ,
where
t (ε, z, σ ) := (e z+g(σ )+σ ε−r − e z )2 ν̃t+1 (z +g(σ )+σ ε, h(ε, σ )).
Then, since t is independent from Ft−1 and thus also from
(Z t−1 , σt ), we obtain
ãt (Z (t−1,i t ) , σ (t, jt ) )
 
= E t t , Z (t−1,i t ) , σ (t, jt )
  
= t ε, Z (t−1,i t ) , σ (t, jt ) f t (ε)dε
R
K  mk

= t (ε, Z (t−1,i t ) , σ (t, jt ) ) f t (ε)dε, (A1)
k=1 m k−1
where −∞ = m 0 < m 1 < . . . < m K −1 < m K = ∞ forms a
partition of the real line and f t (·) is the probability density function
of the innovation t . Provided that (m 1 , m K −1 ) covers the relevant
support of f t (·) and that |m k − m k−1 |, k = 2, . . . , K − 1, are
sufficiently small, we can approximate the integral in expression (A1)
to get our recursion step

K  
ãt (Z (t−1,i t ) , σ (t, jt ) ) ≈ t ε(k) , Z (t−1,i t ) , σ (t, jt )
k=1
 
× F t (m k ) − F t (m k−1 ) ,
where F t is the cumulative distribution function of t and ε(k) ∈
[m k , m k−1 ] for all k. Our implementation of this dynamic program is
based on choices of m k and ε(k) that are analogous to those considered
1318 Feature

by François et al. (2014); they are chosen as quantiles of the distri- When the innovation is assumed GED, E | t−1 | is given by equa-
bution of t . To improve accuracy of the approximation, a relatively tion (B2). The estimated parameters of the EGARCH-GED model are
larger number of quantiles are sampled in the tails of the distribution. given in table B2.
Finally, note that to compute t on the grid Gt , we must be able to
evaluate ν̃t+1 . Since the values of ν̃t+1 are only known on the grid Table B2. Maximum likelihood parameter estimates of the
Gt+1 , we used cubic spline interpolation to approximate this function EGARCH-GED model.
at points that do not lie directly on the grid nodes of Gt+1 .
μ ω α γ β υ
Appendix 2. Description of models used in table 5
0.0445 −0.0039 −0.090 0.116 0.987 1.34
B.1. GED
B.4. RS-GARCH
If X is a GED random variable with zero mean and unit variance, then
its density is given by (see Nelson 1991, equation (2.4)) The RS-GARCH model that we consider is based on the specifica-
    tion introduced by Haas et al. (2004) and extended by Haas (2010).
υ exp − 12 |x/λ|υ Let {X t } be a discrete time Markov chain with finite state space
f X (x) = , −∞ < x < ∞, 0 < υ ≤ ∞, {1, . . . , M} and transition matrix ( pi j )i,Mj=1 , where pi j = Pr(X t =
λ2(1+1/υ) (1/υ)
j | X t−1 = i), for i, j = 1, . . . , M. Assume further that this Markov
where (·) is the gamma function, and chain is hidden from market participants (i.e., unobserved) and that
1/2 the log-return yt depends on this Markov chain in the following way:
λ := 2(−2/υ) (1/υ)/ (3/υ) .
yt = μ X t + σt,X t t ,
The parameter υ controls the tail-thickness of the distribution.
When υ = 2, the GED collapses to the standard normal distribution. where t is a Gaussian innovation with zero mean and unit variance,
For υ < 2, the GED has thicker tails than the normal. The first absolute μ j , j = 1, . . . , M, is a regime-dependent conditional mean parame-
moment of X is given by (see Nelson 1991, equation (A1.8)) ter, and σt,2 j represents the conditional variance process in regime j,
j = 1, . . . , M, which evolves according to the GARCH structure,
E [|X |] = λ21/υ (2/υ)/ (1/υ). (B2)
σt,2 j = ω j + α j (|yt−1 − μ j | − γ j (yt−1 − μ j ))2 + β j σt−1,
2
j,
B.2. GARCH-GED where {ω j , α j , γ j , β j } are parameters of the conditional variance
The GARCH-GED model is the GARCH model in definition 9 with process in regime j, j = 1, . . . , M. The specific RS-GARCH model
a GED innovation. Its estimated parameters are given in table B1. that we estimated assumes M = 2 and the following parameters (see
table B3):    
p11 p12 0.930 0.070
Table B1. Maximum likelihood parameter estimates of the GARCH- =
p21 p22 0.977 0.023
GED model.

μ ω α γ β υ
Table B3. Maximum likelihood parameter estimates of the RS-
0.0483 0.0123 0.0499 0.556 0.922 1.33 GARCH model (M = 2).

j μj ωj αj γj βj
B.3. EGARCH-GED
1 0.066 0.006 0.039 0.536 0.933
The EGARCH model was proposed by Nelson (1991) as an alternative 2 −0.475 0.830 0.440 0.998 0.417
GARCH specification that ensures positivity of the conditional vari-
ance without parametric constraints. The idea consists in modelling
the logarithm of the conditional variance as
 
log(σt2 ) = ω + α t−1 + γ | t−1 | − E | t−1 | + β log(σt−12 ).