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Static Hedging Intro
Intensifying globalization has created tremendous opportunity for the world's corporations and investors. Yet, it has also resulted in increasing risk. As the number of financial transactions continues to proliferate, demand for ever-increasing hedging strategies has grown as well. As the world's markets become more intertwined, they have become more volatile, as changes in one region trickle throughout the global economic system. In response to this, hedging strategies have become more complex.
Where a simple static hedge may have sufficed in the past, risk managers now understand that this type of hedge may not cover their entire exposure with respect to their investment positions. This project attempts to compare static hedging strategies with delta and delta-gamma strategies. A static hedge is a position that is set and then maintained. A delta hedge attempts to remove all volatility in the position with respect to changes in the value of the underlying asset. A gamma-delta hedge goes further, not only offsetting the current delta but the change in delta over a wide range.
Every hedging strategy has costs. For risk managers, transaction costs of complicated options strategies may outweigh the potential benefits. Not every position, after all, needs to be perfectly hedged. This paper will examine the differences between static hedges, delta hedges and gamma-delta hedges. The effectiveness of each of these hedge types will be tested during times of both low volatility and high volatility in the markets.
Previous literature has found that static hedging can outperform delta hedging in the real world, a function of the random walk price fluctuations in the underlying asset and tighter bid-ask spreads on underlying assets vs. options (Carr & Wu, 2002; Englemann et al., 2007). More complicated hedging strategies have an appeal to risk managers who want to show that they have done everything in their power to hedge their company's positions, but ultimately, static hedging may be just as effective. In examining these three different hedging strategies, how they work and what their effects are, we hope to develop a greater understanding of this issue.
Engelmann, Bernd; Fengler, Mattias R.; Nalholm, Morten; Schwender, Peter. (2007). Static verus Dynamic Hedges: an Empirical Comparison for Barrier Options. Review of Derivatives Research. Vol. 9, No 3 pp.239-264.
Carr, Peter & Wu, Liuren. (2002) Static Hedging of Standard Options. Fordham University. Retrieved February 24, 2009 at http://www.bnet.fordham.edu/crif/WorkingPapers/crifwp02010.pdf
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