An approximate distribution of delta-hedging errors in a jump-diffusion model with discrete trading and transaction costs

Abstract

We introduce a jump-diffusion model for asset returns with jumps drawn from a mixture of normal distributions and show that this model adequately fits the historical data of the S&P500 index. We consider a delta-hedging strategy (DHS) for vanilla options under the diffusion model (DM) and the proposed jump-diffusion model (JDM), assuming discrete trading intervals and transaction costs, and derive an approximation for the probability density function (PDF) of the profit-and-loss (P&L) of the DHS under both models. We find that, under the log-normal model of Black–Scholes–Merton, the actual PDF of the P&L can be well approximated by the chi-squared distribution with specific parameters. We derive an approximation for the P&L volatility in the DM and JDM. We show that, under both DM and JDM, the expected loss due to transaction costs is inversely proportional to the square root of the hedging frequency. We apply mean–variance analysis to find the optimal hedging frequency given the hedger's risk tolerance. Since under the JDM it is impossible to reduce the P&L volatility by increasing the hedging frequency, we consider an alternative hedging strategy, following which the P&L volatility can be reduced by increasing the hedging frequency.

Keywords:

• Delta-hedging errors
• Profit & loss distribution
• Discrete trading
• Transaction costs
• Parameters misspecification
• Jump-diffusion model
• Jump risk

Acknowledgements

The author thanks Igor Skachkov for useful discussions and the referees for constructive suggestions and comments. The opinions expressed in this paper are those of the author alone and do not necessarily reflect the views and policies of Bank of America Merrill Lynch.