Managing the volatility risk of portfolios of derivative securities: the Lagrangian uncertain volatility model

Abstract

We present an algorithm for hedging option portfolios and custom-tailored derivative securities, which uses options to manage volatility risk. The algorithm uses a volatility band to model heteroskedasticity and a non- linear partial differential equation to evaluate worst-case volatility scenarios for any given forward liability structure. This equation gives sub-additive portfolio prices and hence provides a natural ordering of prefer- ences in terms of hedging with options. The second element of the algorithm consists of a portfolio optim- ization taking into account the prices of options available in the market. Several examples are discussed, including possible applications to market-making in equity and foreign-exchange derivatives.

Keywords:

• Uncertain volatility
• dynamic hedging
• hedging with options