- Black Scholes
- Be Careful What You Model - 2005
- ucla math 174E
- rdp1999-09
- Articol recenzie econometrie
- Gatheral.1
- WP2002-04-01
- Information Content of Implied Volatility of Asian Equity Indices
- BALLAND-DeterministicImpliedVol
- CBBC or Turbos - Pricing and Risk
- Case Finance Birge
- dictaat.pdf
- Singular Perturbations in Option Pricing
- MFE Notes - 4.26
- Chapter21 (1)
- How Wall Street Adjusts in Times of Higher Volatility
- Recipes
- black-scholes-greeks call option
- 16.Volatility Calculation (Historical) - Zerodha Varsity
- Credit Options
- Stochastic Volatility E®ects on Defaultable Bonds
- Brown Ian
- 2008-09Annual Report Spice Jet
- FinancialDerivatives_063009
- Smiling hybrid
- Hunter Business Group
- Bergomi 1
- Singapore Property Weekly Issue 92.pdf
- AAB CN - Interim Report (2011_Q1) - MD&A
- Project Appraisal
- The Innovators: How a Group of Hackers, Geniuses, and Geeks Created the Digital Revolution
- Dispatches from Pluto: Lost and Found in the Mississippi Delta
- Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic Future
- The Unwinding: An Inner History of the New America
- Yes Please
- Sapiens: A Brief History of Humankind
- The Prize: The Epic Quest for Oil, Money & Power
- The Emperor of All Maladies: A Biography of Cancer
- A Heartbreaking Work Of Staggering Genius: A Memoir Based on a True Story
- This Changes Everything: Capitalism vs. The Climate
- Grand Pursuit: The Story of Economic Genius
- Devil in the Grove: Thurgood Marshall, the Groveland Boys, and the Dawn of a New America
- John Adams
- Smart People Should Build Things: How to Restore Our Culture of Achievement, Build a Path for Entrepreneurs, and Create New Jobs in America
- The Hard Thing About Hard Things: Building a Business When There Are No Easy Answers
- Rise of ISIS: A Threat We Can't Ignore
- The World Is Flat 3.0: A Brief History of the Twenty-first Century
- The New Confessions of an Economic Hit Man
- Team of Rivals: The Political Genius of Abraham Lincoln
- Bad Feminist: Essays
- Steve Jobs
- Angela's Ashes: A Memoir
- How To Win Friends and Influence People
- The Incarnations: A Novel
- You Too Can Have a Body Like Mine: A Novel
- Extremely Loud and Incredibly Close: A Novel
- The Sympathizer: A Novel (Pulitzer Prize for Fiction)
- The Silver Linings Playbook: A Novel
- Leaving Berlin: A Novel
- The Light Between Oceans: A Novel
- The Flamethrowers: A Novel
- Brooklyn: A Novel
- The Rosie Project: A Novel
- The Blazing World: A Novel
- We Are Not Ourselves: A Novel
- The First Bad Man: A Novel
- Bel Canto
- The Master
- A Man Called Ove: A Novel
- The Love Affairs of Nathaniel P.: A Novel
- Life of Pi
- The Cider House Rules
- A Prayer for Owen Meany: A Novel
- The Perks of Being a Wallflower
- The Bonfire of the Vanities: A Novel
- Lovers at the Chameleon Club, Paris 1932: A Novel
- Beautiful Ruins: A Novel
- The Kitchen House: A Novel
- Interpreter of Maladies
- The Wallcreeper
- Wolf Hall: A Novel
- The Art of Racing in the Rain: A Novel
- A Tree Grows in Brooklyn

**com/abstract=1865998
**

When You Hedge Discretely: Optimal

Delta-Hedging Frequency

Artur Sepp

Abstract

We consider the delta-hedging strategy for a vanilla option with discrete hedging

and transaction costs. Assuming that the option is delta-hedged using the Black-

Scholes-Merton model with an implied log-normal volatility, we analyse the proﬁt-and-

loss (P&L) of the delta-hedging strategy given that the actual underlying dynamics

are driven by one of four alternative models: log-normal diﬀusion, jump-diﬀusion,

stochastic volatility and stochastic volatility with jumps. For all of the four cases, we

derive approximations for the expected P&L, expected transaction costs, and P&L

volatility. Using these results, we formulate the problem of ﬁnding the optimal hedging

frequency that maximizes the Sharpe ratio of the delta-hedging strategy. Finally, we

provide some illustrations.

1 Introduction

As opposed to the risk-neutral valuation, in the real world, the delta-hedging strat-

egy is subject to the following key risks: ﬁrst, mis-speciﬁcation of model parame-

ters (El Karoui-Jeanblanc-Shreve (1998)); second, transaction costs (Leland (1985),

Avellaneda-Paras (1994), Toft (1996)); third, discrete hedging (Derman (1999)). The

ﬁrst factor leads to the residual P&L variance that cannot be eliminated by increasing

the hedging frequency. The second one implies that the expected P&L will decrease

when increasing the hedging frequency. The third one results in the inverse rela-

tionship between the P&L variance and the hedging frequency. These considerations

imply a trade-oﬀ between the hedging frequency, the expected P&L and its variance.

In this article, we derive analytical expressions for the expected P&L, transaction costs

and P&L variance. We apply these results to establish an optimal hedging frequency

that maximises the Sharpe ratio of the delta-hedging strategy.

2 Preliminary analysis

For brevity, we assume drift-less dynamics with zero interest and dividend rates,

and time-independent models parameters, as generalization is straightforward. Our

analysis rests on the following assumptions.

2.1 Assumptions

1) We assume that, given an underlying with spot price S(t), a vanilla option on

S(t) with value function U(t, S; σ

i

) is valued under the pricing measure Q using the

1

Electronic copy available at: http://ssrn.com/abstract=1865998

Black-Scholes-Merton PDE with implied volatility σ

i

:

U

t

+

1

2

σ

2

i

S

2

U

SS

= 0, (2.1)

and appropriate terminal condition. The option delta U

S

(t, S; σ

i

) is also computed

by solving (2.1). We assume that volatility σ

i

is implied from a market quote for

U(0, S; σ

i

) and remains ﬁxed up to maturity time T. This assumption states that the

option is priced and delta-hedged at implied volatility. This is a common approach

because, when hedging at a volatility diﬀerent to the implied, the P&L has exposure

to directional changes in the underling price.

2) We assume that the dynamics of underlying price S

∗

(t) under the objective measure

P are speciﬁed according to the SDE:

dS

∗

(t)/S

∗

(t) = σ(...)dW(t), S

∗

(0) = S, (2.2)

that can include jumps and stochastic volatility. We assume that model parameters

of this SDE are estimated for trading and risk-management purposes and that the

expected P&L and its variance are computed under the objective measure P.

3) We assume that the delta-hedging strategy for short position in U is held up

to maturity time T and re-balanced at uniform times {t

n

}, t

n

= nδt, n = 1, .., N,

δt = T/N, t

0

= 0, t

N

= T with total number of trades N.

4) We assume that transaction costs are proportional. These can be interpreted as

the bid-ask spread, which can be estimated empirically based on the stock liquidity

as follows:

k = 2

S

ask

−S

bid

S

ask

+S

bid

,

where S

ask

(S

bid

) is the quoted ask (bid) price. Thus, k/2 is the average percentage loss

per trade amount and, approximately, S

ask

(t) = (1+k/2)S(t) (S

bid

(t) = (1−k/2)S(t)).

2.2 Proﬁt-and-Loss

It is well-known that if the delta-hedge for short position in U is computed using

implied volatility σ

i

then the realized P&L in the absence of transaction costs is

approximately given by:

P({t

n

}) =

N

n=1

σ

2

i

δt −Σ

2

n

Γ(t

n−1

, T, S

∗

; σ

i

), (2.3)

where Σ

2

n

, Σ

2

n

=

S

∗

(t

n

)−S

∗

(t

n−1

)

S

∗

(t

n−1

)

2

, is the variance realized under the objective measure

P and Γ(t, T, S; σ

i

) is the option cash-gamma deﬁned by:

Γ(t, T, S; σ

i

) ≡

1

2

S

2

(t)U

SS

(t, S; σ

i

)

=

K

2

2(T −t)πσ

2

i

exp

_

_

_

−

1

2

ln

S

K

−

1

2

(T −t)σ

2

i

(T −t)σ

2

i

2

_

_

_

(2.4)

2

A continuous-time version of equation (2.3) is obtained by El Karoui-Jeanblanc-Shreve

(1998). Various extensions of it are analysed in Carr (2005), Davis (2010), Sepp

(2011a) who show that this formula is independent from the assumption about the

dynamics of S

∗

(t) and serves as an accurate approximation for the realized P&L.

Finally, following Leland (1985) and Toft (1996), we approximate the realized trans-

action costs by:

C({t

n

}) = k

N

n=1

S

∗

(t

n

)

S

∗

(t

n−1

)

S

∗

(t

n

) −S

∗

(t

n−1

)

S

∗

(t

n−1

)

Γ(t

n−1

, T, S

∗

; σ

i

) (2.5)

2.3 Mean-variance analysis

We analyse the moments of the P&L using the P&L given by formula (2.3). For

this purpose, we need to specify the dynamics (2.2) and analyse the realized variance

Σ

2

n

in (2.3). Importantly, we want to estimate the expected P&L and its variance,

and expected transaction costs. In general, this problem is highly path-dependent

since as cash gamma Γ(t

n−1

, T, S

∗

; σ

i

) depends on the path of S

∗

, as does the realized

variance. However, we derive closed-form approximations which allow to compute

these quantities under the diﬀusion, jump-diﬀusion, and stochastic volatility with

jumps.

In particular, we show that the expected P&L under objective measure P:

U ≡ E

P

[P({t

n

})] , (2.6)

is independent of the hedging frequency N.

The expected transaction costs C(N) can be approximated by:

C(N) ≡ E

P

[C({t

n

})] = c

√

N, (2.7)

where c

2

is the expected transaction cost per trade.

Finally, the variance V (N) can be approximated by:

V (N) = Var

P

[P({t

n

})] =

p

N

+f (2.8)

where p is the variance rate inversely proportional per trade and f is the constant

variance rate. We emphasize that the presence of f in the P&L variance means

that part of the P&L risk, arising from mis-speciﬁcation of model parameters, jumps

and stochastic volatility (or any combination of these factors), cannot be eliminated

by increasing the delta-hedging frequency. We note that the variance of expected

transaction costs is of order k

2

so that its contribution to the P&L variance V (N)

can be ignored.

The above results enable us to represent the Sharpe ratio S(N) of the delta-hedging

strategy by:

S(N) =

u −c

√

N

p

N

+f

, (2.9)

where u = U and constants u, c, v, f are all positive. The speciﬁcation of these

constants depends on the underlying dynamics under P and will be considered in the

following section. For illustrations of S(N) we refer to Figures 1 and 2.

3

The Sharpe ratio is a favourite tool for analysis trading strategies, and, in our set-

ting, it enables to balance the reward of the delta-hedging strategy which is inversely

proportional to hedging frequency with the volatility which is proportional with the

hedging frequency. Our objective is to maximise the Sharpe ratio S(N). We note

that equation (2.9) has a unique global maximum. The stationary point N

∗

solves

the following equation:

−

cp

N

∗

+

up

N

∗

√

N

∗

−cf = 0 (2.10)

Making substitution m = 1/

√

N

∗

, we obtain the cubic equation for m which has one

real and two complex roots. The real-valued root is given by (while m is a real, we

get integer N

∗

= 1/m

2

by rounding):

m = A +

Q

A

+

2c

3u

, A =

|R| +

√

D

1/3

Q =

4

9

c

u

2

, R = −

1

3

c

u

3

+

1

2

cf

up

, D = R

2

−Q

3

> 0

(2.11)

3 Analysis

In this section we consider some speciﬁcations of the P-dynamics (2.2) and derive

constants to use in estimation of the Sharpe ratio (2.9).

3.1 Diﬀusion model

Now we assume that the underlying price S

∗

(t) under the objective measure P is

driven by log-normal diﬀusion with volatility σ

r

:

dS

∗

(t)/S

∗

(t) = σ

r

dW(t), S

∗

(0) = S, (3.1)

where W(t) is standard Brownian motion.

First we introduce the expected cash gamma under P, Γ(t

n

, T; σ

2

r

), n = 0, .., N − 1,

which is given by:

Γ(t

n

, T; σ

2

r

) ≡= E

P

[Γ(t

n

, T, S; σ

i

) | S = S

∗

(t

n

)] = Γ(0, T, S; ζ(t

n

)) (3.2)

where ζ(t

n

) =

(t

n

σ

2

r

+ (T −t

n

)σ

2

i

)/T. If volatility parameters under Q and P are

equal, we obtain that Γ(t

n

, T; σ

r

) = Γ(0, T, S; σ

r

), so that the expected option gamma

at rebalancing times {t

n

} equals to its value at time t

0

= 0.

In Appendix A, we obtain equation (6.3) for an approximation of the expected P&L

under P:

U

df

= (σ

2

i

−σ

2

r

)TΓ

df

,

where Γ

df

is deﬁned by (6.4), and equation (6.8) for an approximation of the P&L

variance which is represented using equation (2.8) with

p

df

= 2qσ

4

r

T

2

Γ

2

df

, f

df

=

σ

2

i

−σ

2

r

2

T

2

Γ

2

df

−(Γ

df

)

2

,

with Γ

2

df

deﬁned by equation (6.6) and q = π

√

3/4.

4

We approximate expected transaction costs by computing expectation in (2.5) and

adjusting the realized variance by q:

C

df

≈ k

N

n=1

σ

2

r

δtΓ(t

n

, T; σ

2

r

) ≈ c

√

N, c = kT

2qσ

2

r

πT

Γ

df

(3.3)

The optimal value of N, so that the Sharpe ratio is maximized, is given by equation

(2.11). To gain some intuition, we consider a simpliﬁed case when the implied volatility

is closed to the realized: σ

i

≈ σ

r

. As a result, f ≈ 0 and the Sharpe ratio becomes:

S

df

=

(σ

2

i

−σ

2

r

)TΓ

df

−kT

2qσ

2

r

πT

Γ

df

√

N

2qσ

4

r

Γ

2

df

N

≈

(σ

2

i

−σ

2

r

) −k

2qσ

2

r

πT

√

N

2qσ

4

r

1

√

N

The Sharpe ratio is maximized by choosing:

N

∗

=

u

2c

=

Tσ

2

r

2

√

3k

2

σ

2

i

σ

2

r

−1

2

(3.4)

with the optimal Sharpe ratio given by:

S =

Tσ

2

r

2k

√

3π

σ

2

i

σ

2

r

−1

2

It is interesting to conclude that with with choice of N

∗

, expected transaction costs

equal to the half of the expected P&L. The optimal frequency is inversely proportional

to the square of the transaction costs, so if transaction costs rate k halves, the optimal

frequency increases four fold and the Sharpe ratio doubles. Also, the Sharpe ratio does

not depend on the expected cash-gamma so that it is little dependent on the strike,

however the Sharpe ratio is expected to increase for options with longer maturity.

Importantly, the optimal frequency is proportional to the ratio of the implied to

realised volatility: the higher is the ratio of the implied volatility to the realized

one, the more frequent becomes the hedging and, as a result, the smaller is the P&L

volatility.

3.2 Jump-diﬀusion model

Now we assume that the underlying dynamics are driven by a jump-diﬀusion process:

dS

∗

(t)/S

∗

(t) = σ

r

dW(t) + (e

ν

−1) dN(t), S

∗

(0) = S, (3.5)

where N(t) is Poisson process with intensity λ. Given a jump in N(t), the jump in

asset log-price has magnitude ν (it is easy to incorporate the volatility of the jump,

but for brevity we do not consider it here).

In appendix A, we show that the expected P&L can be approximated by:

U

jd

= (σ

2

i

−ϑ

jd

(T))TΓ

jd

,

5

where Γ

jd

is deﬁned by equation (6.10) and ϑ

jd

(T) is he expected realized (quadratic)

variance of ln S

∗

(t) under (3.5):

ϑ

jd

(T) = σ

2

r

+ λν

2

Similarly to (3.3), we approximate the expected transaction costs by

C

jd

≈ c

√

N +kλT|ν|Γ

jd

, c = kT

2qσ

2

r

πT

Γ

jd

, (3.6)

where the additional term represent the expected number of jumps and related re-

balancing costs (U

jd

is decreased by this term).

Using equation (6.12), the P&L variance can be represented using equation (2.8) with

p

jd

= qΓ

2

jd

T

2

2σ

4

r

+ 2λσ

2

r

ν

2

f

jd

= qΓ

2

jd

Tλν

4

+

(σ

2

i

−ϑ

jd

)T

2

Γ

2

jd

−(Γ

jd

)

2

where Γ

2

jd

is deﬁned by (6.13).

The Sharpe ratio is given by equation (2.9) with optimal solution speciﬁed by (2.11).

To get some insight, we assume that u is much larger than c (which should be the case

for a trade expected to be proﬁtable). Then we can omit the ﬁrst term in equation

(2.10) to get:

N

∗

=

up

cf

2/3

≈ T

_

_

(σ

2

i

−ϑ

jd

(T) −kλ|ν|) (2σ

4

r

+ 2λσ

2

r

ν

2

)

k

2qσ

2

r

π

λν

4

_

_

2/3

(3.7)

assuming that σ

2

i

≈ ϑ

jd

.

Thus, increasing jump intensity and jump magnitude will decrease the optimal fre-

quency. We note that the optimal frequency depends on the premium of the implied

variance over realised with rate of 2/3 not 2 as in the diﬀusion case (3.4). As a result,

the optimal frequency is expected to be smaller in the presence of jumps. As in the

diﬀusion model, the optimal frequency is proportional to the maturity time.

3.3 Stochastic volatility model

Now we assume that the underlying dynamics are driven by Heston (1993) stochastic

volatility model with stochastic variance V (t):

dS

∗

(t)/S

∗

(t) =

V (t)dW(t), S

∗

(0) = S,

dV (t) = κ(θ −V (t))dt + ε

V (t)dZ(t), V (0) = V,

(3.8)

where W(t) and Z(t) are correlated Brownians with correlation parameter ρ.

Similarly to the jump-diﬀusion model, if the option is delta-hedged using the implied-

volatility σ

i

, then the realized P&L is given by equation (2.3) with realized variance Σ

2

n

sampled using dynamics (3.8). The expected realized (quadratic) variance of ln S

∗

(t)

under (3.8), ϑ

sv

(T), is given by:

ϑ

sv

(T) = θ +

1

κT

1 −e

−κT

(V −θ)

6

We approximate the expected P&L by:

U

sv

= (σ

2

i

−ϑ

sv

)TΓ

sv

−L

sv

, (3.9)

where Γ

sv

is deﬁned by (6.15) and L

sv

is the auto-correlation correction deﬁned by

equation (7.3).

We note that L

sv

is negative so that the stochastic volatility contributes positively to

the expected P&L of a short volatility position. This can be explained that, given

a large value of realized variance Σ

n

, because of the positive correlation between

the instantaneous variance and the realized variance, it is expected that the realized

variance, realized up to time time t

n

, is large and thus the option is likely to be out

of the money with a small value of the cash-gamma. Therefore, even though the n-th

contribution to the P&L is expected to be negative, its magnitude will be mitigated

by a small value of the cash-gamma. In opposite, if realized variance Σ

n

is small, it

is more likely that the option is still at-the-money thus the positive contribution is

magniﬁed by a larger value of the cash-gamma. In a diﬀusion model, the instantaneous

and realized variances are deterministic so that such eﬀect is not observed.

Expected transaction costs are approximated by:

C

sv

= c

√

N, c = kT

2qϑ

sv

(T)

πT

Γ

sv

; (3.10)

while the P&L variance is approximated using (6.18) and given by equation (2.8) with

p

sv

= 2qV

2

T

2

Γ

2

sv

, f

sv

= f

1

+f

2

f

1

= Γ

2

sv

V

sv

, f

2

=

(σ

2

i

−ϑ

sv

)T

2

Γ

2

sv

−(Γ

sv

)

2

,

(3.11)

where Γ

2

sv

is deﬁned by (6.19) and V

sv

is deﬁned by (6.21).

By analogy, the Sharpe ratio is given by (2.9) using coeﬃcients as deﬁned above. To

get some insight, we again assume that u is much larger than c and omit the ﬁrst

term in equation (2.10) to obtain:

N

∗

=

up

cf

2/3

≈ T

_

_

(σ

2

i

−ϑ

sv

)2qϑ

sv

(T)

k

2qV

π

1

3

ε

2

_

_

2/3

(3.12)

assuming σ

2

i

≈ ϑ

sv

(T) and using ﬁrst order expansion f

sv

≈ Γ

2

sv

1

3

V ε

2

T. As a result,

the optimal frequency decreases when ε increases. Similarly to the jump-diﬀusion

model, the optimal frequency increases with the premium σ

2

i

−ϑ

sv

at rate 2/3.

3.4 Stochastic volatility model with jumps

Now we consider stochastic volatility model (3.8) augmented with jumps in price as

in dynamics (3.5). This model is analyses by aggregating available results. First, we

approximate the expected P&L by:

U

svj

= (σ

2

i

−ϑ

svj

)TΓ

svj

−L

sv

, (3.13)

7

where ϑ

svj

= ϑ

sv

+ λν

2

and Γ

svj

is computed using (6.15) and applying (6.17) for

computing (6.16). The transaction cost is approximated by:

C

svj

= c

√

N +kλT|ν|Γ

svj

, c = kT

2qϑ

sv

(T)

πT

Γ

svj

; (3.14)

and the P&L variance is given by equation (2.8) with

p

svj

= 2qΓ

2

sv

V

2

T

2

+ λσ

2

r

ν

2

, f

svj

= f

1

+f

2

+f

3

,

f

1

= Γ

2

svj

V

sv

, f

2

= qΓ

2

svj

Tλν

4

, f

3

=

(σ

2

i

−ϑ

svj

)T

2

Γ

2

svj

−(Γ

svj

)

2

4 Illustrations

In this section, we provide some illustrations using diﬀusion (3.1) (DF), the jump-

diﬀusion (3.5) (JD), stochastic volatility (3.8) (SV) and stochastic volatility with

jumps (SVJ). Model parameters are given in Table 1 and are speciﬁed as follows:

Case I) corresponds to an option on a liquid index or an ETF (such as the S&P 500,

QQQQ, etc); Case II) corresponds to an option on a high-beta stock (such as CAT,

APPL, etc). In the ﬁst case, the implied volatility trades at 10% premium to the

realized volatility with the spread of the implied volatility to the realised one of 1.5%

and transaction costs k = 0.001. In the second case, the implied volatility trades at

20% premium with the spread of 5% and transaction costs k = 0.003. The actual

volatility σ

r

for jump-diﬀusions is adjusted by the contribution from jumps, λν

2

so

that the expected quadratic variance, σ

2

r

+ λν

2

, is the same for all four models. The

option under consideration is call option with S = K = 1, T = 1. The trade notional

is 10000/Γ(0, T, S; σ

i

), where Γ is option cash-gamma deﬁned by (2.4).

In Table 2, we provide coeﬃcients for the Sharpe ratio and the P&L statistics com-

puted using speciﬁed model parameters. In Figure 1, we plot the expected P&L and

its volatility (on left scale) and the corresponding Sharpe ratio (on right scale) as

functions of N for the diﬀusion model with parameters from case I and case II.

In Tables 3 and 4 (5 and 6), we report the expected P&L (P&L), its volatility (Vol),

and corresponding Sharpe ratio (Sharpe) obtained using analytic results (Analytic)

and Monte Carlo (MC) simulations of the diﬀusion and jump-diﬀusion models, re-

spectively, using parameters from case I (case II). Frequency (Freq) corresponding to

N is interpreted as follows (approximately): 1 per m - one re-balancing per month, 1

per w - once per week, 1 per day - once per day, and so on.

For MC simulations, 10000 paths are used. We note that the MC error estimate is

given by the MC P&L volatility divided by 100. Also, conﬁdence bounds for the

Sharpe ration must be even larger because the estimated P&L volatility has the same

MC error estimate. Results obtained by our analytical approximation are within the

MC estimates.

We observe that, for the diﬀusion case, the optimal hedging frequency leads to ex-

pected transaction costs that are about half of the expected upside, in line with equa-

tion (3.4). We note that the optimal frequency under jump-diﬀusion and stochastic

volatility is much smaller than that in the diﬀusion case, in line with conclusions from

equations (3.7) and (3.12). The expected P&L for the stochastic volatility is higher

8

because of the auto-correlation as we have discussed in Section 3.3 and Appendix B.

Importantly, while the expected P&L is about the same for the diﬀusion model and

models with jump and stochastic volatility, the latter models imply much higher P&L

volatility and, as a result, Sharpe ratios. In Figure 2, we illustrate the Sharpe ratio

for all four models. We observe that models with stochastic volatility imply smaller

Sharpe ratios that peak at smaller values of N.

We conclude that the optimal hedging frequency implied by our analysis is conﬁrmed

by MC results. Thus, our analysis can serve to estimate the expected P&L and its

volatility as well as to imply the optimal hedging frequency.

5 Conclusions

We have presented an analytic approach to quantify the expected P&L and it volatility

for a delta-hedging strategy of a vanilla option that is delta-hedged at discrete time

intervals with proportional transaction costs. We have proposed an analytic method

to maximize the Sharpe ratio of the hedging strategy and ﬁnd an optimal hedging

frequency. Our current analysis is best suited for analysing at-the-money options for

which the impact of the skew is limited. A more general analysis that takes into

account the skew is left for future work.

References

[1] Avellaneda, M., and Paras, A., Dynamic hedging portfolios for derivative secu-

rities in the presence of large transaction costs,. Applied Mathematical Finance,

1994, 1, 165-194.

[2] Black, F., Scholes M. , (1973), “The Pricing of Options and Corporate Liabili-

ties,” The Journal of Political Economy, 81, 637-659.

[3] Carr, P. (2005). “Frequently Asked Questions in Option Pricing Theory ,” Jour-

nal of Derivatives, in press.

[4] Davis, M.H.A. (2010). “ Black-Scholes Formula,” in Encyclopedia of Quantitative

Finance, ed. R. Cont, (New York: John Wiley), 199-207.

[5] Derman, E. (1999). “ When You Cannot Hedge Continuously, The Corrections

of Black-Scholes,” RISK, 12(1), 82-85.

[6] El Karoui, N., Jeanblanc, M., Shreve, S. (1998). “ Robustness of the Black and

Scholes formula,” Mathematical Finance, 8(2), 93-126.

[7] Heston, S. (1993). “A closed-form solution for options with stochastic volatility

with applications to bond and currency options,” Review of Financial Studies 6,

327-343.

[8] Leland, H. E. (1985). “Option pricing and replication with transaction costs,”

Journal of Finance 40(5), 1283-1301.

9

[9] Lipton, A. (2002). “The vol smile problem,” Risk, February, 81-85.

[10] Merton, R., (1973) “Theory of Rational Option Pricing,” The Bell Journal of

Economics and Management Science, Vol. 4, No. 1, 141-183.

[11] Sepp, A. (2011a) “Pricing Options on Realized Variance in Heston Model

with Jumps in Returns and Volatility II: An Approximate Distribution

of the Discrete Variance,” Journal of Computational Finance, forthcoming,

ssrn.com/abstract=1664267.

[12] Sepp, A. (2011b) “An Approximate Distribution of Delta-Hedging Errors in a

Jump-Diﬀusion Model with Discrete Trading and Transaction Costs,” Quantita-

tive Finance, forthcoming, ssrn.com/abstract=1360472.

[13] Toft, B.K. (1996). “On the Mean-Variance Tradeoﬀ in Option Replication with

Transactions Costs,” Journal of Financial and Quantitative Analysis 31(2), 233-

263.

6 Appendix A. Mean and Variance of the P&L

We compute the expected value and the variance of the P&L function deﬁned by

(2.3). While the P&L is a path-dependent function as option gamma and the realized

variance depend on the same path as the underlying price, the dependence is mild for

vanilla options. In our analysis we assume independence between the two and apply

the following formula for variance of the product of two independent random variables

X and Y :

Var[XY ] = (E[X])

2

Var[Y ] + (E[Y ])

2

Var[X] +Var[X]Var[Y ]

= E[Y

2

]Var[X] + (E[X])

2

Var[Y ]

(6.1)

For our developments, we deﬁne the quadratic moment generating function of a normal

random variable with mean µ and variance ς as follows:

Z(q

2

, q

1

; µ, ς) ≡

1

√

2πς

∞

−∞

exp

−q

2

x

2

−q

1

x −

(x −µ)

2

2ς

dx

=

1

√

2B + 1

exp

1

2

C

2

2B + 1

−A

,

(6.2)

where B = q

2

ς, C = (2µq

2

+q

1

)

√

ς, A = (q

2

µ

2

+q

1

µ), q

2

> 0.

6.1 Log-normal model

First, we consider the log-normal model with dynamics (2.2):

U

df

≡ E

P

[P(N)] ≈

N

n=1

E

P

σ

2

i

δt −Σ

2

n

E

P

[Γ(t

n−1

, T, S

∗

; σ

i

)]

≈

N

n=1

(σ

2

i

δt −σ

2

r

δt)

E

P

[Γ(T/2, T, S

∗

; σ

i

)]

= (σ

2

i

−σ

2

r

)TΓ

df

,

(6.3)

10

where we apply the mid-point rule to approximate the sum and

Γ

df

= Γ

0, T, S;

(σ

2

r

+ σ

2

i

)/2

(6.4)

To compute the P&L variance, we use (6.1) to obtain:

V

df

≡ V

P

ar [P(N)] ≈ V

P

ar

N

n=1

σ

2

i

δt −Σ

2

n

Γ(T/2, T, S

∗

; σ

i

)

≈ E

P

Γ

2

(T/2, T, S

∗

; σ

i

)

V

P

ar

N

n=1

σ

2

i

δt −Σ

2

n

+

E

P

N

n=1

σ

2

i

δt −Σ

2

n

2

V

P

ar [Γ(T/2, T, S

∗

; σ

i

)]

(6.5)

Using formula (6.2), we get:

Γ

2

df

≡ E

P

Γ

2

(T/2, T, S

∗

; σ

i

)

= Γ

2

(0, T/2, S; σ

i

)E

P

e

−q

2

X

2

(T/2)−q

1

X(T/2)

= Γ

2

(0, T/2, S; σ

i

)Z

q

2

, q

1

; −

Tσ

2

r

4

,

Tσ

2

r

2

(6.6)

where q

2

= 1/(Tσ

2

i

/2), q

1

= 2(ln(S/K)−Tσ

2

i

/4)/(Tσ

2

i

/2) and X(T) = ln(S(T)/S(0))

with S

∗

(t) driven by dynamics (3.1). After simpliﬁcation and omitting the exponent:

Γ

2

df

≈

Γ

2

(0, T/2, S; σ

i

)

2

σ

2

r

σ

2

i

+ 1

(6.7)

The variance of the realized variance in the log-normal model, taking log-returns, is

given by:

V

P

ar

N

n=1

Σ

2

n

≈ V

P

ar

N

n=1

ln

S

∗

(t

n

)

S

∗

(t

n−1

)

2

=

2σ

4

r

T

2

N

As a result, the P&L variance is given by:

V

df

= Γ

2

π

√

3

4

2σ

4

r

T

2

N

+

σ

2

i

−σ

2

r

2

T

2

Γ

2

−(Γ

df

)

2

,

(6.8)

where multiplier π

√

3/4 arises from normalizing the exact value of integral

T

0

T

2

dt/

√

T

2

−t

2

=

π/2 by the value obtained by the mid-point approximation 2/

√

3. In this way, if

σ

i

= σ

r

the above formula coincides with equation (1) in Derman (1999).

6.2 Jump-diﬀusion model

Similarly to (6.6), under the jump-diﬀusion model (3.5) we obtain:

U

jd

≡ E

P

[P(N)] ≈ (σ

2

i

−ϑ

jd

)TΓ

jd

, (6.9)

11

where

Γ

jd

≡ E

P

[Γ(T/2, T, S

∗

; σ

i

)] = Γ(T/2, T, S

∗

; σ

i

)Q

jd

(T/2; q

2

/2, q

1

/2), (6.10)

and q

2

, q

1

are deﬁned as in (6.6). Here Q

jd

(T; q

2

, q

1

) is computed by conditioning on

the number of jumps as follows:

Q

jd

(T; q

2

, q

1

) ≡ E

P

e

−q

2

X

2

(T)−q

1

X(T)

=

∞

m=0

e

−λT

(λT)

m

m!

Z

q

2

, q

1

; −σ

2

r

T/2 +mν, σ

2

r

T +mυ

(6.11)

where X(T) = ln(S

∗

(T)/S

∗

(0)) with S

∗

(t) driven by (3.5).

Using (6.5) for the P&L variance we get:

V

jd

≈ V

P

ar

N

n=1

σ

2

i

δt −Σ

2

n

Γ(T/2, T, S

∗

; σ

i

)

≈ Γ

2

jd

V

P

ar

N

n=1

Σ

2

n

+

(σ

2

i

−ϑ

jd

)T

2

Γ

2

jd

−(Γ

jd

)

2

(6.12)

where

Γ

2

jd

= Γ

2

(0, T/2, S; σ

i

)Q

jd

(T/2; q

2

, q

1

) (6.13)

V

P

ar

N

n=1

Σ

2

n

≈

(2σ

4

r

+ 2λσ

2

r

ν

2

)T

2

N

+ λTν

4

(6.14)

6.3 Stochastic volatility model

Similarly to (6.6), under the stochastic volatility dynamics (3.8) we get approximate

the expected P&L using equation (3.9) where

Γ

sv

≡ E

P

[Γ(T/2, T, S

∗

; σ

i

)] = Γ(T/2, T, S

∗

; σ

i

)Q

sv

(T/2; q

2

/2, q

1

/2) (6.15)

and Q

sv

(T; q

2

, q

1

) is computed as follows:

Q

sv

(T; q

2

, q

1

) ≡ E

P

e

−q

2

X

2

(T)−q

1

X(T)

=

1

√

πq

2

∞

0

exp

(ik −1/2 −q

1

)

2

4q

2

+ α

(SV)

(T, k) + (k

2

+ 1/4)β

(SV)

(T, k)V

dk,

(6.16)

where X(T) = ln(S

∗

(T)/S

∗

(0)) with S

∗

(t) driven by (3.8) and α

(SV)

(T, k) and β

(SV)

(T, k)

are deﬁned by equation (7) in Lipton (2001):

α

(SV)

(T, k) = −

κθ

ε

2

ψ

+

T + 2 ln

ψ

−

+ ψ

+

e

−ζT

2ζ

, β

(SV)

(T, k) = −

1 −e

−ζT

ψ

−

+ ψ

+

e

−ζT

ψ

±

= ∓(ikρε + ˆ κ) + ζ, ζ =

k

2

ε

2

(1 −ρ

2

) + 2ikερˆ κ + ˆ κ

2

+ ε

2

/4, ˆ κ = κ −ρε/2

12

Under the stochastic volatility with jumps we use α

(SVJ)

(T, k) augmented as follows:

α

(SVJ)

(T, k) = α

(SV)

(T, k) + λT

e

(−ik+1/2)ν

−1

(6.17)

Using (6.5), for the P&L variance we get:

V

sv

≈ V

P

ar

N

n=1

σ

2

i

δt −Σ

2

n

Γ(T/2, T, S

∗

; σ

i

)

≈ Γ

2

sv

V

P

ar

N

n=1

Σ

2

n

+

(σ

2

i

−ϑ

sv

)T

2

Γ

2

sv

−(Γ

sv

)

2

(6.18)

where

Γ

2

sv

= Γ

2

(0, T/2, S; σ

i

)Q

sv

(T/2; q

2

, q

1

) (6.19)

and (see equation (9) in Sepp (2011b))

V

P

ar

N

n=1

Σ

2

n

≈

2V

2

T

2

N

+V

sv

(6.20)

V

sv

=

ε

2

2κ

3

(θ −2V )e

−2κT

+ 4(θκT −V κT + θ)e

−κT

+ (−5θ + 2θκT + 2V )

(6.21)

7 Appendix B. Auto-covariance

As we have discussed in Sections 3.3, under the stochastic volatility dynamics, it is

important to account for the autocorrelation of the variance dynamics. Here we derive

an approximation assuming ρ = 0 and leaving non-zero case for future developments.

For negative correlation, the correction to the expected P&L turns out to be higher

than our estimate but not signiﬁcantly.

We consider a simpliﬁed discrete version of the dynamics (3.8):

S(t

n

) = S(t

n−1

)e

√

V

n−1

δt

n

, (7.1)

where V

n

= V (t

n

). Then the P&L function (2.3) becomes:

P({t

n

}) ≈

N

n=1

σ

2

i

δt −V

n

δt

2

n

Γ(t

n−1

, T, S

0

e

n−1

m=1

√

V

m−1

δt

m

; σ

i

)

=

N

n=1

σ

2

i

δt −V

n

δt

2

n

Γ(t

n−1

, T, S

0

e

n−1

m=1

√

V

m−1

δt

m

; σ

i

)

−

N

n=1

V

n

δt

2

n

−V

n

δt

2

n

Γ(t

n−1

, T, S

0

e

n−1

m=1

√

V

m−1

δt

m

; σ

i

)

(7.2)

13

where V

n

= E[V (t

n

)]. The expectation of the ﬁrst part is approximated using equation

(3.9). For the second one, we consider:

L({t

n

}) ≡

N

n=1

V

n

−V

n

δt

2

n

Γ(t

n−1

, T, S

0

e

n−1

m=1

√

V

m−1

δt

m

; σ

i

)

=

N

n=1

V

n

−V

n

δt

2

n

C

n−1

exp

_

_

_

−

1

2

n−1

m=1

V

m−1

δt

m

(T −t

n−1

)σ

2

i

+y

n−1

2

_

_

_

≈

N

n=1

V

n

−V

n

δt

2

n

C

n−1

exp

_

¸

_

¸

_

−

1

2

n−1

m=1

V

m−1

δt

m

2

(T −t

n−1

)σ

2

i

− y

n−1

n−1

m=1

V

m−1

δt

m

(T −t

n−1

)σ

2

i

−

1

2

y

2

n−1

_

¸

_

¸

_

where C

n−1

=

K

2

√

2(T−t

n−1

)πσ

2

i

, y

n−1

=

ln

S

0

K

−

1

2

(T−t

n−1

)σ

2

i

√

(T−t

n−1

)σ

2

i

, y

n−1

=

−

1

2

(T−t

n−1

)σ

2

i

√

(T−t

n−1

)σ

2

i

= −

1

2

(T −t

n−1

)σ

2

i

.

Computing the ﬁrst-order expectation with respect to

n

ﬁrst and taking I(t

n−1

) ≡

n−1

m=1

V

m−1

δt ≈

t

m−1

0

V (s)ds, we obtain:

L

sv

≡ E

P

[L({t

n

})] ≈

N

n=1

E

P

V

n

−V

n

δtC

n−1

e

−

1

2

y

2

n−1

e

−Ψ

n−1

I(t

n−1

)

≈

N

n=1

δtC

n−1

e

−

1

2

y

2

n−1

G(t

n−1

, V, Ψ

n−1

)

(7.3)

where Ψ

n−1

= (3/8)/((T −t

n−1

)σ

2

i

) and

G(T, V, Ψ) with V (T) = E[V (T)] is computed

using equation (40) in Sepp (2011b) as follows:

G(T, V, Ψ) ≡ E

V (T) −V (T)

e

−ΨI(T)

= −

∂

∂Θ

G

(V I)

(Θ, Ψ; 0, T, V ) |

Θ=0

−V (T)

G

(V I)

(Θ, Ψ; 0, T, V ) |

Θ=0

= −(A

Θ

(T, Ψ) +B

Θ

(T, Ψ)V ) e

A(T,Ψ)+B(T,Ψ)V

,

(7.4)

A(T, Ψ) = −

κθ

ε

2

ψ

+

T + 2 ln

ψ

−

+ ψ

+

e

−ζT

2ζ

, B(T, Ψ) = −2Ψ

1 −e

−ζT

ψ

−

+ ψ

+

e

−ζT

,

A

Θ

(T, Ψ) = 2κθ

1 −e

−ζT

ψ

−

+ ψ

+

e

−ζT

+ (1 −e

−κT

)θ, B

Θ

(T, Ψ) =

e

−ζT

ψ

2

−

+ ψ

2

+

+ 2ψ

−

ψ

+

ψ

−

+ ψ

+

e

−ζT

+e

−κT

,

ψ

±

= ∓κ + ζ, ζ =

√

κ

2

+ 2ε

2

Ψ

We note that

G(T, V, Ψ) ≈ ε

2

T so that E

P

[L({t

n

})] deﬁned by (7.3) is little dependent

for the step size δt and can be computed at once for all values of N.

14

Table 1: Model Parameters

Case I Case II

DF JD SV SVJ DF JD SV SVJ

σ

i

16.50% 16.50% 16.50% 16.50% 30.00% 30.00% 30.00% 30.00%

k 0.001 0.001 0.001 0.001 0.003 0.003 0.003 0.003

σ

r

15% 14.14% 25% 22.91%

λ 1.00 1.00 1.00 1.00

ν -5% -5% -10% -10%

V 15%

2

14.14%

2

25%

2

22.91%

2

θ 15%

2

14.14%

2

25%

2

22.91%

2

κ 4.00 4.00 4.00 4.00

ε 0.30 0.30 0.60 0.60

ρ 0.00 0.00 0.00 0.00

Table 2: Sharpe ratio parameters

Case I Case II

DF JD SV SVJ DF JD SV SVJ

u 0.4946% 0.4794% 0.6079% 0.5895% 2.9928% 2.8619% 3.4479% 3.2907%

c 0.0146% 0.0135% 0.0148% 0.0136% 0.0760% 0.0673% 0.0771% 0.0681%

p 0.1696% 0.1463% 0.1739% 0.1495% 1.3876% 1.1123% 1.4303% 1.1388%

f 0.0003% 0.0013% 0.0104% 0.0101% 0.0092% 0.0276% 0.1294% 0.1237%

N

∗

203 126 57 56 163 95 49 47

C(N

∗

) 0.21% 0.15% 0.11% 0.10% 0.97% 0.66% 0.54% 0.47%

u −C(N

∗

) 0.29% 0.33% 0.50% 0.49% 2.02% 2.21% 2.91% 2.82%

(V (N

∗

))

1/2

0.34% 0.50% 1.16% 1.13% 1.33% 1.98% 3.98% 3.85%

S(N

∗

) 0.85 0.66 0.43 0.43 1.52 1.11 0.73 0.73

Figure 1: The expected P&L and volatility (left scale) and corresponding Sharpe ratio

(right scale) for the diﬀusion model using parameters from case I (left side) and from

case II (right side)

0.0%

0.3%

0.5%

0.8%

1.0%

1.3%

1.5%

10 100 190 280 370 460 550 640 730 820 910 1000

N

E

x

p

e

c

t

e

d

P

&

L

,

V

o

l

a

t

i

l

i

t

y

0.00

0.20

0.40

0.60

0.80

1.00

S

h

a

r

p

e

R

a

t

i

o

Expected P&L (lhs)

P&L Volatility (lhs)

Sharpe Ratio (rhs)

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

10 100 190 280 370 460 550 640 730 820 910 1000

N

E

x

p

e

c

t

e

d

P

&

L

,

V

o

l

a

t

i

l

i

t

y

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

S

h

a

r

p

e

R

a

t

i

o

Expected P&L (lhs)

P&L Volatility (lhs)

Sharpe Ratio (rhs)

15

Figure 2: The Sharpe ratio for models using parameters from case I (left side) and

from case II (right side)

0.0

0.2

0.4

0.6

0.8

1.0

10 100 190 280 370 460 550 640 730 820 910 1000

N

S

h

a

r

p

e

r

a

t

i

o

DF JD SV SVJ

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

10 100 190 280 370 460 550 640 730 820 910 1000

N

S

h

a

r

p

e

r

a

t

i

o

DF JD SV SVJ

Table 3: Case I, diﬀusion and jump-diﬀusion models

N Freq DF, MC DF, Analytic JD, MC JD, Analytic

P&L Vol Sharpe P&L Vol Sharpe P&L Vol Sharpe P&L Vol Sharpe

Optimal 2.90 3.29 0.88 2.86 3.37 0.85 3.40 5.10 0.67 3.28 5.01 0.66

15 1 per m 4.23 10.91 0.39 4.38 10.77 0.41 3.97 11.14 0.36 4.27 10.54 0.41

30 2 per m 4.04 7.79 0.52 4.15 7.72 0.54 3.99 8.44 0.47 4.06 7.89 0.51

60 1 per w 3.78 5.83 0.65 3.81 5.59 0.68 3.80 6.46 0.59 3.75 6.15 0.61

120 2 per w 3.31 4.18 0.79 3.35 4.14 0.81 3.44 5.20 0.66 3.32 5.06 0.66

240 1 per d 2.75 2.98 0.92 2.68 3.18 0.84 2.91 4.27 0.68 2.71 4.42 0.61

480 2 per d 1.98 2.19 0.90 1.74 2.56 0.68 2.15 3.80 0.57 1.84 4.06 0.45

960 4 per d 0.83 1.49 0.55 0.42 2.19 0.19 1.15 3.36 0.34 0.62 3.87 0.16

Table 4: Case I, stochastic volatility and stochastic volatility with jump models

N Freq SV, MC SV, Analytic SVJ, MC SVJ, Analytic

P&L Vol Sharpe P&L Vol 0.71 P&L Vol Sharpe P&L Vol Sharpe

Optimal 4.86 12.41 0.39 4.96 11.61 0.43 4.50 12.23 0.37 4.88 11.29 0.43

15 1 per m 5.16 15.82 0.33 5.51 14.84 0.37 4.95 15.45 0.32 5.37 14.16 0.38

30 2 per m 4.95 13.38 0.37 5.27 12.74 0.41 4.54 13.24 0.34 5.15 12.27 0.42

60 1 per w 4.66 12.39 0.38 4.93 11.55 0.43 4.34 12.16 0.36 4.84 11.21 0.43

120 2 per w 4.41 11.54 0.38 4.46 10.90 0.41 4.18 11.45 0.36 4.40 10.64 0.41

240 1 per d 3.64 11.26 0.32 3.79 10.56 0.36 3.87 10.80 0.36 3.78 10.35 0.37

480 2 per d 3.05 11.11 0.27 2.83 10.39 0.27 2.99 10.97 0.27 2.91 10.19 0.29

960 4 per d 2.16 11.12 0.19 1.49 10.30 0.14 2.16 10.89 0.20 1.67 10.12 0.17

16

Table 5: Case II, diﬀusion and jump-diﬀusion models

N Freq DF, MC DF, Analytic JD, MC JD, Analytic

P&L Vol Sharpe P&L Vol Sharpe P&L Vol Sharpe P&L Vol Sharpe

Optimal 20.27 13.02 1.56 20.23 13.30 1.52 22.71 20.76 1.09 22.06 19.82 1.11

15 1 per m 26.04 34.01 0.77 26.99 31.89 0.85 24.78 35.88 0.69 26.01 31.90 0.82

30 2 per m 24.95 25.34 0.98 25.77 23.54 1.09 24.62 28.36 0.87 24.93 25.43 0.98

60 1 per w 23.51 19.09 1.23 24.04 17.97 1.34 23.59 23.42 1.01 23.41 21.48 1.09

120 2 per w 21.56 14.60 1.48 21.61 14.40 1.50 21.71 20.10 1.08 21.25 19.20 1.11

240 1 per d 18.58 11.18 1.66 18.16 12.23 1.49 18.79 17.52 1.07 18.20 17.95 1.01

480 2 per d 14.37 8.38 1.71 13.29 10.98 1.21 15.39 15.66 0.98 13.88 17.29 0.80

960 4 per d 8.43 5.65 1.49 6.39 10.30 0.62 10.03 14.22 0.71 7.78 16.96 0.46

Table 6: Case II, stochastic volatility and stochastic volatility with jump models

N Freq SV, MC SV, Analytic SVJ, MC SVJ, Analytic

P&L Vol Sharpe P&L Vol Sharpe P&L Vol Sharpe P&L Vol Sharpe

Optimal 28.85 43.73 0.66 29.08 39.83 0.73 27.81 42.55 0.65 28.24 38.46 0.73

15 1 per m 29.99 53.96 0.56 31.51 47.41 0.66 27.56 51.47 0.54 30.28 44.68 0.68

30 2 per m 29.92 47.34 0.63 30.26 42.08 0.72 28.04 45.95 0.61 29.18 40.21 0.73

60 1 per w 28.04 43.66 0.64 28.50 39.15 0.73 26.55 41.84 0.63 27.63 37.77 0.73

120 2 per w 26.42 41.65 0.63 26.03 37.60 0.69 24.78 40.47 0.61 25.45 36.50 0.70

240 1 per d 22.84 40.26 0.57 22.53 36.79 0.61 22.68 39.10 0.58 22.36 35.84 0.62

480 2 per d 19.10 40.35 0.47 17.58 36.39 0.48 20.22 39.28 0.51 17.99 35.51 0.51

960 4 per d 14.27 40.97 0.35 10.58 36.18 0.29 14.65 39.36 0.37 11.80 35.34 0.33

17

approximately. σi ).1) and appropriate terminal condition. 2. tN = T with total number of trades N . σi ) 2 1 ln S − 1 (T − t)σ 2 2 K i K 2 = exp − 2 2 2 2 2(T − t)πσi (T − t)σi 2 2 σi δt − Σ2 Γ(tn−1 .com/abstract=1865998 .2) that can include jumps and stochastic volatility.. when hedging at a volatility diﬀerent to the implied. σi ) and remains ﬁxed up to maturity time T . δt = T /N .. is the variance realized under the objective measure n n P and Γ(t. 2) We assume that the dynamics of underlying price S ∗ (t) under the objective measure P are speciﬁed according to the SDE: dS ∗ (t)/S ∗ (t) = σ(. These can be interpreted as the bid-ask spread. T. T.. the P&L has exposure to directional changes in the underling price. (2. N . 2 (2. S. σi ) is also computed by solving (2. 4) We assume that transaction costs are proportional. tn = nδt. Sask (t) = (1+k/2)S(t) (Sbid (t) = (1−k/2)S(t)). S ∗ (0) = S. n = 1.1). We assume that volatility σi is implied from a market quote for U (0. Sask + Sbid where Sask (Sbid ) is the quoted ask (bid) price. which can be estimated empirically based on the stock liquidity as follows: k=2 Sask − Sbid . S.3) (2. t0 = 0. k/2 is the average percentage loss per trade amount and. σi ) is the option cash-gamma deﬁned by: 1 Γ(t. σi ) ≡ S 2 (t)USS (t. S ∗ .4) Electronic copy available at: http://ssrn. This is a common approach because.2 Proﬁt-and-Loss It is well-known that if the delta-hedge for short position in U is computed using implied volatility σi then the realized P&L in the absence of transaction costs is approximately given by: P ({tn }) = N n=1 ∗ 2 ∗ n )−S (t where Σ2 . 3) We assume that the delta-hedging strategy for short position in U is held up to maturity time T and re-balanced at uniform times {tn }. S. .)dW (t).. This assumption states that the option is priced and delta-hedged at implied volatility. S. Thus. n (2. The option delta US (t. We assume that model parameters of this SDE are estimated for trading and risk-management purposes and that the expected P&L and its variance are computed under the objective measure P. Σ2 = S (tS ∗ (tn−1 )n−1 ) . T.Black-Scholes-Merton PDE with implied volatility σi : 1 2 Ut + σi S 2 USS = 0. S.

We emphasize that the presence of f in the P&L variance means that part of the P&L risk. σi ) depends on the path of S ∗ . In general. f are all positive. we derive closed-form approximations which allow to compute these quantities under the diﬀusion. Finally.2) and analyse the realized variance Σ2 in (2.9) +f N where u = U and constants u. Sepp (2011a) who show that this formula is independent from the assumption about the dynamics of S ∗ (t) and serves as an accurate approximation for the realized P&L. In particular. cannot be eliminated by increasing the delta-hedging frequency. Finally. we approximate the realized transaction costs by: N S ∗ (tn ) S ∗ (tn ) − S ∗ (tn−1 ) Γ(tn−1 . 3 . following Leland (1985) and Toft (1996).3). The above results enable us to represent the Sharpe ratio S(N ) of the delta-hedging strategy by: √ u−c N S(N ) = p . (2. For this purpose. For illustrations of S(N ) we refer to Figures 1 and 2. we show that the expected P&L under objective measure P: U ≡ EP [P ({tn })] .6) (2. the variance V (N ) can be approximated by: V (N ) = VarP [P ({tn })] = p +f N (2. The speciﬁcation of these constants depends on the underlying dynamics under P and will be considered in the following section. this problem is highly path-dependent since as cash gamma Γ(tn−1 . Davis (2010).7) where p is the variance rate inversely proportional per trade and f is the constant variance rate. The expected transaction costs C(N ) can be approximated by: √ C(N ) ≡ EP [C({tn })] = c N .3). arising from mis-speciﬁcation of model parameters.3 Mean-variance analysis We analyse the moments of the P&L using the P&L given by formula (2. jump-diﬀusion. We note that the variance of expected transaction costs is of order k 2 so that its contribution to the P&L variance V (N ) can be ignored. T. as does the realized variance. Various extensions of it are analysed in Carr (2005). σi ) C({tn }) = k (2. where c2 is the expected transaction cost per trade. jumps and stochastic volatility (or any combination of these factors). However.3) is obtained by El Karoui-Jeanblanc-Shreve (1998). n and expected transaction costs. S ∗ . S ∗ . c. is independent of the hedging frequency N . v. we need to specify the dynamics (2. T. we want to estimate the expected P&L and its variance. Importantly.5) S ∗ (tn−1 ) S ∗ (tn−1 ) n=1 2. and stochastic volatility with jumps.A continuous-time version of equation (2.8) (2.

σr ). so that the expected option gamma at rebalancing times {tn } equals to its value at time t0 = 0. In Appendix A. T .11) 4 c 2 1 c 3 1 cf Q= . If volatility parameters under Q and P are equal.8) with 2 4 2 2 pdf = 2qσr T 2 Γ2 df . . fdf = σi − σr T 2 Γ2 df − (Γdf )2 . σr ) = Γ(0.. in our setting. S. n = 0. it enables to balance the reward of the delta-hedging strategy which is inversely proportional to hedging frequency with the volatility which is proportional with the hedging frequency. S. and equation (6. T. and. We note that equation (2.1 Diﬀusion model Now we assume that the underlying price S ∗ (t) under the objective measure P is driven by log-normal diﬀusion with volatility σr : dS ∗ (t)/S ∗ (t) = σr dW (t). S.8) for an approximation of the P&L variance which is represented using equation (2. N − 1. Γ(tn . Our objective is to maximise the Sharpe ratio S(N ). σi ) | S = S ∗ (tn )] = Γ(0. √ with Γ2 df deﬁned by equation (6.The Sharpe ratio is a favourite tool for analysis trading strategies. T . T .2) and derive constants to use in estimation of the Sharpe ratio (2. we obtain that Γ(tn . R=− + . 3. 2 First we introduce the expected cash gamma under P. we obtain the cubic equation for m which has one real and two complex roots. T. we get integer N ∗ = 1/m2 by rounding): √ 1/3 Q 2c m = A + + . where Γdf is deﬁned by (6.6) and q = π 3/4.. D = R2 − Q3 > 0 9 u 3 u 2 up 3 Analysis In this section we consider some speciﬁcations of the P-dynamics (2.9) has a unique global maximum.2) Γ(tn .9).10) √ ∗ − cf = 0 N N∗ N √ Making substitution m = 1/ N ∗ . which is given by: 2 (3.1) where W (t) is standard Brownian motion. we obtain equation (6. S ∗ (0) = S. T. σr ). (3. ζ(tn )) 2 2 where ζ(tn ) = (tn σr + (T − tn )σi )/T . σr ) ≡= EP [Γ(tn . 4 . A = |R| + D A 3u (2. The real-valued root is given by (while m is a real.4).3) for an approximation of the expected P&L under P: 2 2 U df = (σi − σr )T Γdf . The stationary point N ∗ solves the following equation: cp up − ∗+ (2.

is given by equation (2. T .3) πT n=1 The optimal value of N . but for brevity we do not consider it here). so that the Sharpe ratio is maximized. the Sharpe ratio does not depend on the expected cash-gamma so that it is little dependent on the strike. Importantly.4) with the optimal Sharpe ratio given by: 2 2 2 T σr σi S= √ −1 2 2k 3π σr It is interesting to conclude that with with choice of N ∗ . Now we assume that the underlying dynamics are driven by a jump-diﬀusion process: (3. however the Sharpe ratio is expected to increase for options with longer maturity. In appendix A. As a result. so if transaction costs rate k halves. S ∗ (0) = S. Given a jump in N (t). f ≈ 0 and the Sharpe ratio becomes: √ 2 2√ 2 2 2 2 (σi − σr )T Γdf − kT 2qσr Γdf N (σi − σr ) − k 2qσr N πT πT S df = ≈ 4 4 2qσr Γ2 df 2qσr √1N N The Sharpe ratio is maximized by choosing: ∗ u T σ2 N = = √ r 2c 2 3k 2 2 2 σi −1 2 σr (3. 3.2 Jump-diﬀusion model dS ∗ (t)/S ∗ (t) = σr dW (t) + (eν − 1) dN (t). The optimal frequency is inversely proportional to the square of the transaction costs. expected transaction costs equal to the half of the expected P&L.5) and adjusting the realized variance by q: N 2 √ 2qσr 2 2 C df ≈ k σr δtΓ(tn . Also. as a result.We approximate expected transaction costs by computing expectation in (2. σr ) ≈ c N . the more frequent becomes the hedging and. c = kT Γdf (3. we show that the expected P&L can be approximated by: 2 U jd = (σi − ϑjd (T ))T Γjd . 5 .11). the optimal frequency is proportional to the ratio of the implied to realised volatility: the higher is the ratio of the implied volatility to the realized one. the optimal frequency increases four fold and the Sharpe ratio doubles.5) where N (t) is Poisson process with intensity λ. we consider a simpliﬁed case when the implied volatility is closed to the realized: σi ≈ σr . To gain some intuition. the smaller is the P&L volatility. the jump in asset log-price has magnitude ν (it is easy to incorporate the volatility of the jump.

The Sharpe ratio is given by equation (2.6) where the additional term represent the expected number of jumps and related rebalancing costs (U jd is decreased by this term). we assume that u is much larger than c (which should be the case for a trade expected to be proﬁtable). Thus. The expected realized (quadratic) variance of ln S ∗ (t) under (3. (3.8). ϑsv (T ).9) with optimal solution speciﬁed by (2.5): 2 ϑjd (T ) = σr + λν 2 Similarly to (3. Using equation (6. increasing jump intensity and jump magnitude will decrease the optimal frequency. we approximate the expected transaction costs by 2 √ 2qσr C jd ≈ c N + kλT |ν|Γjd .4). is given by: ϑsv (T ) = θ + 1 1 − e−κT (V − θ) κT 6 . the optimal frequency is expected to be smaller in the presence of jumps.3). As a result. if the option is delta-hedged using the impliedvolatility σi .13). Then we can omit the ﬁrst term in equation (2.10) to get: 2/3 2/3 2 4 2 2 up (σ − ϑjd (T ) − kλ|ν|) (2σr + 2λσr ν ) (3. the optimal frequency is proportional to the maturity time. V (0) = V.12).8).10) and ϑjd (T ) is he expected realized (quadratic) variance of ln S ∗ (t) under (3.8) with 4 2 2 pjd = qΓjd T 2 2σr + 2λσr ν 2 2 2 2 4 2 − (Γ )2 fjd = qΓjd T λν + (σi − ϑjd )T Γ jd jd where Γ2 jd is deﬁned by (6.11). Similarly to the jump-diﬀusion model. As in the diﬀusion model. We note that the optimal frequency depends on the premium of the implied variance over realised with rate of 2/3 not 2 as in the diﬀusion case (3.where Γjd is deﬁned by equation (6. To get some insight.7) N∗ = ≈T i 2 cf 2qσr 4 k λν π 2 assuming that σi ≈ ϑjd .3 Stochastic volatility model Now we assume that the underlying dynamics are driven by Heston (1993) stochastic volatility model with stochastic variance V (t): dS ∗ (t)/S ∗ (t) = V (t)dW (t). then the realized P&L is given by equation (2. πT (3. the P&L variance can be represented using equation (2. where W (t) and Z(t) are correlated Brownians with correlation parameter ρ. S ∗ (0) = S. c = kT Γjd .3) with realized variance Σ2 n sampled using dynamics (3.8) dV (t) = κ(θ − V (t))dt + ε V (t)dZ(t). 3.

Expected transaction costs are approximated by: √ 2qϑsv (T ) C sv = c N . we approximate the expected P&L by: 2 U svj = (σi − ϑsvj )T Γsvj − Lsv . it is more likely that the option is still at-the-money thus the positive contribution is magniﬁed by a larger value of the cash-gamma.15) and Lsv is the auto-correlation correction deﬁned by equation (7.5).10) to obtain: N∗ = up cf 2/3 2 (σi ≈T 2 assuming σi ≈ ϑsv (T ) and using ﬁrst order expansion fsv ≈ Γ2 sv 1 V ε2 T . Therefore. (3. if realized variance Σn is small.We approximate the expected P&L by: 2 U sv = (σi − ϑsv )T Γsv − Lsv .18) and given by equation (2. To get some insight. In a diﬀusion model.11) where Γ2 sv is deﬁned by (6.19) and Vsv is deﬁned by (6. c = kT Γsv .8) with psv = 2qV 2 T 2 Γ2 sv . its magnitude will be mitigated by a small value of the cash-gamma. In opposite. This model is analyses by aggregating available results.4 Stochastic volatility model with jumps Now we consider stochastic volatility model (3.10) πT while the P&L variance is approximated using (6. − ϑsv )2qϑsv (T ) k 2qV 1 ε2 π 3 2/3 (3. even though the n-th contribution to the P&L is expected to be negative. sv sv − (Γsv ) i (3. We note that Lsv is negative so that the stochastic volatility contributes positively to the expected P&L of a short volatility position. (3.12) 3. the Sharpe ratio is given by (2. we again assume that u is much larger than c and omit the ﬁrst term in equation (2. 3 the optimal frequency decreases when ε increases. By analogy. fsv = f1 + f2 2 2 V . (3. is large and thus the option is likely to be out of the money with a small value of the cash-gamma.13) 7 . it is expected that the realized variance.21).9) using coeﬃcients as deﬁned above.9) where Γsv is deﬁned by (6. the instantaneous and realized variances are deterministic so that such eﬀect is not observed. given a large value of realized variance Σn . First.3). This can be explained that.8) augmented with jumps in price as in dynamics (3. Similarly to the jump-diﬀusion 2 model. As a result. realized up to time time tn . the optimal frequency increases with the premium σi − ϑsv at rate 2/3. f = (σ 2 − ϑ )T 2 Γ2 f1 = Γ sv sv 2 . because of the positive correlation between the instantaneous variance and the realized variance.

4). The transaction cost is approximated by: √ 2qϑsv (T ) C svj = c N + kλT |ν|Γsvj . S.17) for computing (6. In the second case. is the same for all four models. etc). Case II) corresponds to an option on a high-beta stock (such as CAT. the implied volatility trades at 20% premium with the spread of 5% and transaction costs k = 0. using parameters from case I (case II). c = kT Γsvj . respectively.12). Model parameters are given in Table 1 and are speciﬁed as follows: Case I) corresponds to an option on a liquid index or an ETF (such as the S&P 500. In Figure 1.003.5% and transaction costs k = 0. and corresponding Sharpe ratio (Sharpe) obtained using analytic results (Analytic) and Monte Carlo (MC) simulations of the diﬀusion and jump-diﬀusion models. For MC simulations. In Table 2. etc). The trade notional is 10000/Γ(0. 2 2 f1 = Γ2 svj Vsv . We note that the MC error estimate is given by the MC P&L volatility divided by 100. QQQQ. 1 per day . fsvj = f1 + f2 + f3 .one re-balancing per month. we provide coeﬃcients for the Sharpe ratio and the P&L statistics computed using speciﬁed model parameters. the optimal hedging frequency leads to expected transaction costs that are about half of the expected upside. In Tables 3 and 4 (5 and 6). The expected P&L for the stochastic volatility is higher 8 .once per week. We observe that.8) (SV) and stochastic volatility with jumps (SVJ). the implied volatility trades at 10% premium to the realized volatility with the spread of the implied volatility to the realised one of 1.7) and (3.001. The actual volatility σr for jump-diﬀusions is adjusted by the contribution from jumps. we provide some illustrations using diﬀusion (3. its volatility (Vol).where ϑsvj = ϑsv + λν 2 and Γsvj is computed using (6. 1 per w .once per day. we plot the expected P&L and its volatility (on left scale) and the corresponding Sharpe ratio (on right scale) as functions of N for the diﬀusion model with parameters from case I and case II.1) (DF). for the diﬀusion case. T = 1. We note that the optimal frequency under jump-diﬀusion and stochastic volatility is much smaller than that in the diﬀusion case. Also. and so on. stochastic volatility (3. in line with conclusions from equations (3. σr + λν 2 . (3.5) (JD). in line with equation (3. λν 2 so 2 that the expected quadratic variance.8) with 2 psvj = 2qΓ2 sv V 2 T 2 + λσr ν 2 . σi ). The option under consideration is call option with S = K = 1. APPL. In the ﬁst case.15) and applying (6. 10000 paths are used. conﬁdence bounds for the Sharpe ration must be even larger because the estimated P&L volatility has the same MC error estimate. f2 = qΓ2 svj T λν 4 .4). Results obtained by our analytical approximation are within the MC estimates. we report the expected P&L (P&L).14) πT and the P&L variance is given by equation (2. the jumpdiﬀusion (3. f3 = (σi − ϑsvj )T Γ2 svj − (Γsvj )2 4 Illustrations In this section. where Γ is option cash-gamma deﬁned by (2.16). Frequency (Freq) corresponding to N is interpreted as follows (approximately): 1 per m . T.

(2010). We observe that models with stochastic volatility imply smaller Sharpe ratios that peak at smaller values of N . in press. E. References [1] Avellaneda. We conclude that the optimal hedging frequency implied by our analysis is conﬁrmed by MC results. 1. Thus. (New York: John Wiley). “ When You Cannot Hedge Continuously. [2] Black. M. ed. “Frequently Asked Questions in Option Pricing Theory . We have proposed an analytic method to maximize the Sharpe ratio of the hedging strategy and ﬁnd an optimal hedging frequency. In Figure 2. “ Robustness of the Black and Scholes formula. 82-85. (1999). (1998). R. P. N. 5 Conclusions We have presented an analytic approach to quantify the expected P&L and it volatility for a delta-hedging strategy of a vanilla option that is delta-hedged at discrete time intervals with proportional transaction costs. 165-194. M. 8(2).” Review of Financial Studies 6. S.” RISK. 93-126.because of the auto-correlation as we have discussed in Section 3. we illustrate the Sharpe ratio for all four models.” Journal of Derivatives. 81. Jeanblanc. A. F.” The Journal of Political Economy. Our current analysis is best suited for analysing at-the-money options for which the impact of the skew is limited. “Option pricing and replication with transaction costs.. 1994.. H. . (1985). The Corrections of Black-Scholes. [4] Davis. E. [5] Derman. [6] El Karoui. “ Black-Scholes Formula.. Scholes M. as a result..A. [8] Leland.” Mathematical Finance. our analysis can serve to estimate the expected P&L and its volatility as well as to imply the optimal hedging frequency. M. (1973). and Paras. Shreve.. 327-343. 1283-1301. 199-207. (2005). Dynamic hedging portfolios for derivative securities in the presence of large transaction costs. Sharpe ratios. 637-659. [3] Carr.3 and Appendix B. Importantly. “A closed-form solution for options with stochastic volatility with applications to bond and currency options. A more general analysis that takes into account the skew is left for future work.” Journal of Finance 40(5). 12(1). Cont. 9 . the latter models imply much higher P&L volatility and. Applied Mathematical Finance.H. “The Pricing of Options and Corporate Liabilities. [7] Heston.. while the expected P&L is about the same for the diﬀusion model and models with jump and stochastic volatility.” in Encyclopedia of Quantitative Finance. (1993). S.

10 .1 Log-normal model N n=1 First. B. forthcoming. we deﬁne the quadratic moment generating function of a normal random variable with mean µ and variance ς as follows: ∞ 1 (x − µ)2 2 Z(q2 . the dependence is mild for vanilla options. 6. S ∗ . [11] Sepp. No.2): U df ≡ EP [P (N )] ≈ ≈ = EP 2 σi δt − Σ2 n n=1 2 (σi − N 2 (σi δt − 2 σr δt) EP [Γ(tn−1 .com/abstract=1360472. T. q1 . 1. (2002).” Risk. A.2) 1 2 C 1 2 =√ exp −A .3) EP [Γ(T /2. [10] Merton. [12] Sepp. 4. R. q2 > 0.[9] Lipton. ssrn.K. 141-183. “On the Mean-Variance Tradeoﬀ in Option Replication with Transactions Costs. we consider the log-normal model with dynamics (2. (2011a) “Pricing Options on Realized Variance in Heston Model with Jumps in Returns and Volatility II: An Approximate Distribution of the Discrete Variance.” Journal of Computational Finance. (2011b) “An Approximate Distribution of Delta-Hedging Errors in a Jump-Diﬀusion Model with Discrete Trading and Transaction Costs. ς) ≡ √ exp −q2 x − q1 x − dx 2ς 2πς −∞ (6.. T. 6 Appendix A. Vol. µ. [13] Toft. Mean and Variance of the P&L We compute the expected value and the variance of the P&L function deﬁned by (2.” Quantitative Finance. 233263. σi )] 2 σr )T Γdf . 81-85.” The Bell Journal of Economics and Management Science. In our analysis we assume independence between the two and apply the following formula for variance of the product of two independent random variables X and Y : Var[XY ] = (E[X])2 Var[Y ] + (E[Y ])2 Var[X] + Var[X]Var[Y ] (6. S ∗ .com/abstract=1664267. forthcoming. ssrn. C = (2µq2 + q1 ) ς.1) = E[Y 2 ]Var[X] + (E[X])2 Var[Y ] For our developments. (1996). “The vol smile problem. While the P&L is a path-dependent function as option gamma and the realized variance depend on the same path as the underlying price.” Journal of Financial and Quantitative Analysis 31(2). A = (q2 µ2 + q1 µ). σi )] (6. A.3). February. 2B + 1 2B + 1 √ where B = q2 ς. A. (1973) “Theory of Rational Option Pricing.

S.2 Jump-diﬀusion model 2 U jd ≡ EP [P (N )] ≈ (σi − ϑjd )T Γjd . T. S ∗ . S ∗ . is given by: N N 2 S ∗ (tn ) 2σ 4 T 2 VP ar Σ2 ≈ VP ar ln ∗ = r n S (tn−1 ) N n=1 n=1 Γ2 (0. T /2.6). T /2. Similarly to (6. T. T. S ∗ .5) + 2 2 n=1 VP ar [Γ(T /2.6) 2 2 2 where q2 = 1/(T σi /2). 6. 4 N √ √ T where multiplier π 3/4 arises from normalizing the exact value of integral 0 T 2 dt/ T 2 − t2 = √ π/2 by the value obtained by the mid-point approximation 2/ 3. we get: 2 Γ2 ≡ EP Γ2 (T /2. σi ) n n=1 (6.where we apply the mid-point rule to approximate the sum and 2 + σ 2 )/2 Γdf = Γ 0. T.1).4) N 2 P 2 ≈ EP Γ (T /2. σi ) V ar σi δt − Σ2 n EP N n=1 2 σi δt − Σn (6. the P&L variance is given by: √ 4 π 3 2σr T 2 2 2 2 2 (6.5) we obtain: (6. taking log-returns. if σi = σr the above formula coincides with equation (1) in Derman (1999).1) to obtain: N 2 V df ≡ VP ar [P (N )] ≈ VP ar σi δt − Σ2 Γ(T /2. σi )] Using formula (6. 4 2 (6. σi ) 2 ≈ 2 σr + 1 σ2 i (6.7) As a result. − . S. q1 . σi ) = Γ2 (0. After simpliﬁcation and omitting the exponent: Γ2 df The variance of the realized variance in the log-normal model. S ∗ . we use (6. σi )EP e−q2 X (T /2)−q1 X(T /2) df 2 2 T σr T σr 2 = Γ (0. σi )Z q2 . S. under the jump-diﬀusion model (3. T. (σr i To compute the P&L variance.2). T /2. In this way. S.8) V df = Γ + σi − σr T 2 Γ2 − (Γdf )2 .9) 11 . q1 = 2(ln(S/K)−T σi /4)/(T σi /2) and X(T ) = ln(S(T )/S(0)) ∗ with S (t) driven by dynamics (3.

S. k) and β (SV) (T. S ∗ . σi )Qjd (T /2.14) 6. σr T + mυ m! m=0 (6. −σr T /2 + mν.where Γjd ≡ EP [Γ(T /2. q1 ) N 4 2 (2σr + 2λσr ν 2 )T 2 VP ar Σ2 ≈ + λT ν 4 n N n=1 (6. Here Qjd (T . σi )Qsv (T /2. πq2 0 4q2 (6. σi )] = Γ(T /2.10) and q2 .3 Stochastic volatility model Similarly to (6. q1 ) is computed by conditioning on the number of jumps as follows: 2 Qjd (T . q1 ) is computed as follows: 2 Qsv (T . q1 are deﬁned as in (6.11) where X(T ) = ln(S ∗ (T )/S ∗ (0)) with S ∗ (t) driven by (3. k) = − 2 ψ+ T + 2 ln . ζ = k 2 ε2 (1 − ρ2 ) + 2ikερˆ + κ2 + ε2 /4. S ∗ . T.5) for the P&L variance we get: N 2 V jd ≈ VP ar σi δt − Σ2 Γ(T /2. q2 . κ = κ − ρε/2 ˆ κ ˆ ˆ 12 .5). T /2. σi ) n ≈ Γ2 jd VP ar where n=1 N n=1 2 Σ2 + (σi − ϑjd )T n 2 Γ2 jd − (Γjd )2 (6. Using (6. T. S ∗ . q2 . k)V dk. σi )Qjd (T /2. q2 . σi )] = Γ(T /2. q1 ) ≡ EP e−q2 X (T )−q1 X(T ) ∞ e−λT (λT )m 2 2 = Z q2 . q1 /2). q2 .13) (6. q2 /2. k) are deﬁned by equation (7) in Lipton (2001): κθ ψ− + ψ+ e−ζT 1 − e−ζT (SV) α (T. T. q2 . k) = − ε 2ζ ψ− + ψ+ e−ζT ψ± = ∓(ikρε + κ) + ζ.16) where X(T ) = ln(S ∗ (T )/S ∗ (0)) with S ∗ (t) driven by (3.6).15) and Qsv (T .8) we get approximate the expected P&L using equation (3.6).8) and α(SV) (T. k) + (k + 1/4)β (T. T. β (SV) (T. T. (6. q1 ) ≡ EP e−q2 X (T )−q1 X(T ) ∞ 1 (ik − 1/2 − q1 )2 (SV) 2 (SV) =√ exp +α (T. q1 . S ∗ . under the stochastic volatility dynamics (3. q2 /2.9) where Γsv ≡ EP [Γ(T /2. q1 /2) (6.12) Γ2 jd = Γ2 (0. S ∗ .

Here we derive an approximation assuming ρ = 0 and leaving non-zero case for future developments.3.3) becomes: P ({tn }) ≈ = − N N n=1 n−1 √ 2 σi δt − Vn δt2 Γ(tn−1 . T. the correction to the expected P&L turns out to be higher than our estimate but not signiﬁcantly. σi ) n ≈ Γ2 sv VP ar where Γ2 sv = Γ2 (0. k) = α(SV) (T. σi ) n n=1 N n=1 n−1 √ Vn δt2 − V n δt2 Γ(tn−1 . under the stochastic volatility dynamics. q2 . S0 e m=1 Vm−1 δtm . for the P&L variance we get: N 2 Vsv ≈ VP ar σi δt − Σ2 Γ(T /2. it is important to account for the autocorrelation of the variance dynamics. S0 e m=1 Vm−1 δtm .5). S ∗ . S.18) (6. σi ) n n n−1 √ 2 σi δt − V n δt2 Γ(tn−1 .19) (6.Under the stochastic volatility with jumps we use α(SVJ) (T.8): √ S(tn ) = S(tn−1 )e Vn−1 δtn .1) where Vn = V (tn ). For negative correlation. σi )Qsv (T /2.2) 13 . T. T /2. T. Then the P&L function (2.21) 2κ3 7 Appendix B. k) + λT e(−ik+1/2)ν − 1 (6. k) augmented as follows: α(SVJ) (T. T. S0 e m=1 Vm−1 δtm . We consider a simpliﬁed discrete version of the dynamics (3. q1 ) and (see equation (9) in Sepp (2011b)) N 2V 2 T 2 VP ar Σ2 ≈ + Vsv n N n=1 Vsv = n=1 N n=1 2 Σ2 + (σi − ϑsv )T n 2 Γ2 sv − (Γsv )2 (6.20) ε2 (θ − 2V )e−2κT + 4(θκT − V κT + θ)e−κT + (−5θ + 2θκT + 2V ) (6. σi ) n (7. Auto-covariance As we have discussed in Sections 3. (7.17) Using (6.

Ψn−1 ) κθ ψ− + ψ+ e−ζT 1 − e−ζT A(T. T.4) G (Θ. Ψ) + BΘ (T. Ψ) = 2κθ + (1 − e−κT )θ. ε 2ζ ψ− + ψ+ e−ζT 2 2 e−ζT ψ− + ψ+ + 2ψ− ψ+ 1 − e−ζT AΘ (T. Ψ) ≈ ε2 T so that EP [L({tn })] deﬁned by (7. V. For the second one. Ψ) = − 2 ψ+ T + 2 ln . 0. G(tn−1 .Ψ)V . Ψ) with V (T ) = E[V (T )] is computed using equation (40) in Sepp (2011b) as follows: G(T. The expectation of the ﬁrst part is approximated using equation (3. Ψ) = + e−κT . yn−1 = √ = −1 2 2 (T −tn−1 )σi 1 2 2 (T − tn−1 )σi .3) δtCn−1 e 2 where Ψn−1 = (3/8)/((T −tn−1 )σi ) and G(T. 2 2(T −tn−1 )πσi Vn − V n−1 √ Vm−1 δtm 2 m=1 . we consider: L({tn }) ≡ N N n=1 where Cn−1 = √ 2 2 1 n−1 V m−1 δtm m=1 = Vn − V n δt2 Cn−1 exp − + yn−1 n 2 2 (T − tn−1 )σi n=1 2 n−1 n−1 N 1 Vm−1 δtm 2 m=1 Vm−1 δtm 1 2 m=1 ≈ Vn − V n δtn Cn−1 exp − − yn−1 − yn−1 2 2 2 (T − tn−1 )σi (T − tn−1 )σi 2 n=1 K . σi ) n δtn Γ(tn−1 . BΘ (T. ζ = κ2 + 2ε2 Ψ We note that G(T. Ψ) ≡ E V (T ) − V (T ) e−ΨI(T ) ∂ (V I) (7. V. T. V.3) is little dependent for the step size δt and can be computed at once for all values of N . EP 1 2 Vn − V n δtCn−1 e− 2 yn−1 e−Ψn−1 I(tn−1 ) 2 − 1 yn−1 2 (7. V. 0. S0 e yn−1 = ln Computing the ﬁrst-order expectation with respect to n ﬁrst and taking I(tn−1 ) ≡ tm−1 n−1 V (s)ds. we obtain: m=1 Vm−1 δt ≈ 0 Lsv ≡ E [L({tn })] ≈ ≈ P N n=1 N n=1 S0 2 − 1 (T −tn−1 )σi K 2 2 (T −tn−1 )σi √ − 2 (T −tn−1 )σi . Ψ.where V n = E[V (tn )].Ψ)+B(T. Ψ)V ) eA(T.9). Ψ. V ) |Θ=0 =− ∂Θ = − (AΘ (T. ψ− + ψ+ e−ζT ψ− + ψ+ e−ζT √ ψ± = ∓κ + ζ. B(T. 14 . V ) |Θ=0 − V (T )G(V I) (Θ. Ψ) = −2Ψ . T.

33% 0.1495% 0.11 SV 3.9928% 0.0% Expected P&L (lhs) P&L Volatility (lhs) Sharpe Ratio (rhs) 1.30 0.40 0.8% 0.5% 1.00 -10% 22.30 0.1696% 0.001 SVJ 16.73 SVJ 3.00 -5% SV 16.43 Case II DF 2.003 22.0% 1.00 -5% 14.0146% 0.40 1.0148% 0.0% 10 100 190 280 370 460 550 640 730 820 910 0.σi k σr λ ν V θ κ ε ρ Case I DF 16.54% 2.20 0.3876% 0.00 0.98% 0.1388% 0. Volatility Expected P&L (lhs) P&L Volatility (lhs) Sharpe Ratio (rhs) 0.21% 0.91%2 22.0003% 203 0.15% 0.00 0.80 1.1294% 49 0.11% 0.50% 0.00 Case II DF 30.1463% 0.0101% 56 0.80 Expected P&L.0% 2.00% 0.14%2 14.50% 1.0276% 95 0.50% 0.85 Table 2: Sharpe ratio parameters JD 0.00 25%2 25%2 4.14% 1.73 Figure 1: The expected P&L and volatility (left scale) and corresponding Sharpe ratio (right scale) for the diﬀusion model using parameters from case I (left side) and from case II (right side) 1.00% 0.00 15%2 15%2 4.00 1000 15 .85% 0.91%2 4.0771% 1.1739% 0.0135% 0. Volatility 4.5% 0.00 5.60 0.0760% 1.60 1.8619% 0.21% 1.66% 2.98% 1.60 0.14%2 4.6079% 0.1123% 0.1237% 47 0.13% 0.001 15% Table 1: Model Parameters JD 16.4303% 0.47% 2.0104% 57 0.82% 3.60 0.3% 1.0681% 1.001 14.97% 2.4479% 0.50% 0.43 SVJ 0.00 1000 Sharpe Ratio 3.0% N 0.49% 1.00% 0.001 1.0673% 1.16% 0.00 0.0136% 0.40 0.66 SV 0.2907% 0.60 0.33% 1.91% 1.00 -10% SV 30.10% 0.0% 10 100 190 280 370 460 550 640 730 820 910 0.50% 0.003 SVJ 30.003 25% JD 30.00 0.4946% 0.00% 0.52 JD 2.91% 3.00 0.0013% 126 0.3% Expected P&L.5895% 0.0% 0.003 1.02% 1.29% 0.0% 0.4794% 0.20 N 0.20 Sharpe Ratio 1.0092% 163 0.00 u c p f N∗ C(N ∗ ) u − C(N ∗ ) (V (N ∗ ))1/2 S(N ∗ ) Case I DF 0.50% 0.34% 0.

42 4.2 0.83 MC Vol 3.80 10.36 0.88 0.66 4.64 3.41 0.74 11.16 MC Vol 12. stochastic volatility and stochastic volatility with jump models SV.27 0.79 0.06 4. P&L 4.26 11.19 10.79 5.90 4.2 1.62 Analytic Vol 5.84 0.37 0.34 4.89 Sharpe 0.0 10 100 190 280 370 460 550 640 730 820 910 1000 N N Freq Optimal 1 per m 2 per m 1 per w 2 per w 1 per d 2 per d 4 per d 15 30 60 120 240 480 960 DF.98 0.55 DF.32 0.99 2.2 N 0.37 10.41 0.18 2.77 7.56 2.37 0.90 10.16 11.4 0.85 0.51 5.66 0.68 0.19 Sharpe 0.43 0.15 4.20 4.38 12.40 3.61 14.04 3.15 3.68 0.47 0.01 10.97 3.54 4.36 0.84 12.78 3.6 0.37 0.83 1.0 1.34 0.74 0.29 10.19 JD.71 1.33 0.54 11.19 SV.61 0.41 3.14 8.34 Sharpe ratio JD.Figure 2: The Sharpe ratio for models using parameters from case I (left side) and from case II (right side) 1.95 4.39 0.78 2.16 N Freq Optimal 1 per m 2 per m 1 per w 2 per w 1 per d 2 per d 4 per d Table 4: Case I.29 14.51 0.8 DF JD SV SVJ DF JD SV SVJ Sharpe ratio 0.28 4.68 1.91 7.82 13.32 2.16 4.67 15 30 60 120 240 480 960 Analytic Vol 11.79 2.41 15.27 11.66 0.42 0.40 3.83 4.27 3.27 4.86 4.87 2.18 2.37 0.05 2.35 2.88 5.98 2.45 13.43 0.20 SVJ. P&L 4.18 3.54 7. diﬀusion and jump-diﬀusion models Sharpe 0. P&L 4. P&L 3.65 0.30 0.80 3.41 0. P&L 2.81 0.27 0.80 3.41 0.15 MC Vol 5.31 2.54 0.14 SVJ.45 10.46 3.0 0.64 10.16 MC Vol 12.46 5.39 0.57 0.6 0.6 1.12 Sharpe 0.91 1.61 0.49 Table 3: Case I.27 4.91 2.16 12.84 0.21 10.4 1.29 0.59 4. P&L 3.06 3. P&L 2.43 0.92 0.44 6.87 Sharpe 0.72 5.4 0.23 4. P&L 4.75 3.90 0.37 5.66 0.38 4.10 11.45 0.38 0.42 Analytic Vol 3.75 1.71 0.17 16 .15 5.81 3.12 Sharpe 0.14 3.49 Analytic Vol 11.93 4.59 0.27 0.96 5.56 10.89 6.84 4.38 0.67 0.41 0.38 0.0 10 100 190 280 370 460 550 640 730 820 910 1000 0.44 2.19 1.99 3.68 0.39 11.86 5.06 3.39 10.15 1.36 Sharpe 0.97 10.95 4.24 12.23 15.55 10.35 10.36 0.50 4.43 0.11 11.8 0.36 0.36 0.32 0.52 0.

78 24.52 0.22 Sharpe 1.09 1.65 40.41 42.73 0.98 1.58 14.28 29.57 0.76 35.24 30.62 JD.62 0.84 40.15 37.43 21.34 1.07 0.97 Sharpe 0.61 0.85 29.81 27.66 14.96 Sharpe 1.30 Sharpe 1.84 19.78 22.66 0.73 0.65 Table 5: Case II.34 43.46 44.69 0.39 36.58 Analytic Vol 39.29 6.48 19.77 24.30 31.04 21. P&L 28.68 0.51 21.40 12.35 SV.35 40.26 40.03 MC Vol 20.92 28.41 21.11 1.96 47.48 0.47 0. stochastic volatility and stochastic volatility with jump models SV.47 39.71 18.68 20.98 1.50 26.61 0.18 27.55 24.98 0.68 40.46 N Freq Optimal 1 per m 2 per m 1 per w 2 per w 1 per d 2 per d 4 per d Table 6: Case II.29 16.73 0.56 0.36 17.01 24.23 1.79 36.59 21.99 29.65 MC Vol 42.20 17.29 SVJ.88 7.27 26.04 26.51 0.36 23.88 28.73 0.55 51.18 8. P&L 29. P&L 22.06 26.95 17.66 0.54 17.10 39.80 0.51 30.45 22.47 45.61 18.03 22.52 15.21 37.34 19.58 0.80 15 30 60 120 240 480 960 Analytic Vol 38. P&L 20. P&L 20.71 24.70 0.77 0.23 10.23 26.04 24.49 DF.01 25.82 0.50 35.48 1.N Freq Optimal 1 per m 2 per m 1 per w 2 per w 1 per d 2 per d 4 per d 15 30 60 120 240 480 960 DF.16 13.66 41.37 8.63 0.56 0. P&L 22.39 Analytic Vol 13.71 1.73 53.33 17 .62 23.09 1.99 25.51 35.95 23.50 1.77 36.99 11.27 MC Vol 43.37 SVJ.78 Analytic Vol 19.60 11.83 47.63 0.42 22.82 31.51 0.66 1.89 23.64 0.49 1.60 36.61 0.08 39.34 Sharpe 0.71 JD. P&L 28. P&L 27.90 25.25 18.84 35.95 41.72 0.01 0.20 13.63 0.98 10.85 1.69 0.54 0.58 10.21 0.10 17.10 14.97 14.38 5.09 0.53 17.02 34.18 Sharpe 0.42 20.65 0. diﬀusion and jump-diﬀusion models Sharpe 1.08 31.09 14.28 39.22 14.39 10.08 1.04 26.73 0.63 25.56 18.79 15.87 1.11 0.93 23.43 MC Vol 13.36 Sharpe 0.26 28.01 1.56 28.

- Black ScholesUploaded bymiche345
- Be Careful What You Model - 2005Uploaded byJoariso
- ucla math 174EUploaded byHoang Trung Nguyen
- rdp1999-09Uploaded byreachernie
- Articol recenzie econometrieUploaded byRoman Cezar
- Gatheral.1Uploaded byZhenhuan Song
- WP2002-04-01Uploaded byakshay12489
- Information Content of Implied Volatility of Asian Equity IndicesUploaded byRahul Pinnamaneni
- BALLAND-DeterministicImpliedVolUploaded byfloqflo
- CBBC or Turbos - Pricing and RiskUploaded byJasvinder Josen
- Case Finance BirgeUploaded bySavinai Vangala
- dictaat.pdfUploaded byGisselaPozo
- Singular Perturbations in Option PricingUploaded byTu Shirota
- MFE Notes - 4.26Uploaded byAlistair Rook
- Chapter21 (1)Uploaded byNak Van
- How Wall Street Adjusts in Times of Higher VolatilityUploaded byHenry Daniels
- RecipesUploaded bynekougolo3064
- black-scholes-greeks call optionUploaded byapi-295319283
- 16.Volatility Calculation (Historical) - Zerodha VarsityUploaded byravi4paper
- Credit OptionsUploaded byQuant2020
- Stochastic Volatility E®ects on Defaultable BondsUploaded byTu Shirota
- Brown IanUploaded bygbs1012
- 2008-09Annual Report Spice JetUploaded byAbbas Murtaza Hadi
- FinancialDerivatives_063009Uploaded byMisbah Rehman
- Smiling hybridUploaded byRachid Serkhane
- Hunter Business GroupUploaded bySharath Reddy
- Bergomi 1Uploaded byharsjus
- Singapore Property Weekly Issue 92.pdfUploaded byPropwise.sg
- AAB CN - Interim Report (2011_Q1) - MD&AUploaded byelombardi1
- Project AppraisalUploaded byBigyan Shrestha