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Delta hedging strategies comparison

Article  in  European Journal of Operational Research · March 2008

DOI: 10.1016/j.ejor.2006.08.019 · Source: DBLP

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 European Journal of Operational Research 185 (2008) 1615–1631
www.elsevier.com/locate/ejor

Delta hedging strategies comparison

Domenico De Giovanni d, Sergio Ortobelli a,*
, Svetlozar Rachev b,c

a
Department of Mathematics, Institute of Economy, University of Bergamo, Italy
b
University of Karlsruhe, Germany
c
University of California, Santa Barbara, CA, USA
d
University of Calabria, Italy

Available online 11 October 2006

Abstract

In this paper we implement dynamic delta hedging strategies based on several option pricing models. We analyze dif-
ferent subordinated option pricing models and we examine delta hedging costs using ex-post daily prices of S&P 500. Fur-
thermore, we compare the performance of each subordinated model with the Black–Scholes model.
Ó 2006 Elsevier B.V. All rights reserved.

Keywords: Delta hedging; Subordinated models; Option pricing; Stable motion; Incomplete markets

1. Introduction

The main aim of this paper is to compare the costs of hedging strategies driven by pricing models based on
different subordinated processes. We provide several models to price contingent claims which generalize the
classical Black–Scholes model. In particular, we show how subordinated models can be used in order to
decrease the costs of delta hedging strategies. The method used goes back to the seminal work of Mandelbrot
and Taylor (1967).
It is well-known that the asset returns are not normally distributed. Nevertheless, many of the concepts in
theoretical and empirical finance developed over the past decades rest upon the assumption that the asset
returns follow a normal distribution. The fundamental work of Mandelbrot (1963a,b, 1967) and Fama
(1963, 1965a,b) has sparked considerable interest in studying the empirical distribution of financial assets.
The excess kurtosis found in Mandelbrot and Fama’s investigations led them to reject the normal assumption
and to propose the stable Paretian distribution as a statistical model for asset returns. The Fama and Man-
delbrot’s conjecture was supported by numerous empirical investigations in the subsequent years (see Rachev
and Mittnik, 2000). The practical and theoretical appeal of the stable non-Gaussian approach is given by its
attractive properties that are almost the same as the normal ones.
In our paper, we analyze the dynamic structure of return processes using subordinated laws and we show
how subordinated models can be used to price contingent claims. The subordinated asset price models we

*
Corresponding author. Tel.: +39 0352052564; fax: +39 0352052549.
E-mail address: sergio.ortobelli@unibg.it (S. Ortobelli).

0377-2217/$ - see front matter Ó 2006 Elsevier B.V. All rights reserved.
doi:10.1016/j.ejor.2006.08.019
1616 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631

are going to consider are the following: the Mandelbrot Paretian stable model (see Mandelbrot and Taylor,
1967), the Hyperbolic model (see Barndorff-Nielsen, 1995; Eberlein and Keller, 1995; Bibby and Soresen,
2003), the log Student’s t model (see Blattberg and Gonedes, 1974; Hurst et al., 1997), the Clark model
(see Clark, 1973), the Log Laplace model (see Mittnik and Rachev, 1993). Thus, we examine the subordi-
nated stable model in option pricing and we propose an empirical comparison among dynamic delta
hedging strategies adopting either the classical Black–Scholes option pricing model or other subordinated
models.
In Section 2 we review recent option pricing models. Section 3 compares different delta hedging strategies.
Finally, we briefly summarize the results.

2. Subordinated processes

This section discusses subordinated option pricing models. A large part of modern finance has been con-
cerned with modeling the evolution of return processes over time. Typically, using subordinated processes,
it is possible to capture empirically observed anomalies that contradict the classical log-normality assumption
for asset prices. That is, we substitute the physical or calendar time with an intrinsic or operational time which
provides distribution tail effects often observed in the market. Thus, if W = {W(t), t P 0} is a stochastic pro-
cess and T = {T(t), t P 0} is a non-negative stochastic process on the same probability space and adapted to
the same filtration, a new process Z = {Z(t) = W(T(t)), t P 0} may be formed and it is defined as subordinated
to W by the intrinsic time process T. The intrinsic time process T = {T(t), t P 0} usually represents the cumu-
lative trading volume process which measures the total volume of all the transactions up to the physical time t.
Whereas the process W represents the noise process introduced in the intrinsic time scale. Next, we will assume
that W is a standard Wiener process. In this case, if the intrinsic time process T is the deterministic physical
time (that is T(t) = t), we obtain the classical log-normal model (see Samuelson, 1955; Osborne, 1959). Nor-
mally, subordinated models with random intrinsic time are leptokurtic with heavier tails than the normal dis-
tribution. When the intrinsic time process has non-negative stationary independent increments, then the
subordinated process Z also has stationary independent increments (see Feller, 1966).
Generally, we assume frictionless1 markets where the log price process Z is subordinated to a standard Wie-
ner process W by the independent intrinsic time process T. Thus, the asset price process S(t) assumes the fol-
lowing stochastic form:
Z t Z t Z t 
SðtÞ ¼ Sðt0 Þ exp lðsÞ ds þ qðsÞ dT ðsÞ þ rðsÞ dW ðT ðsÞÞ ;
t0 t0 t0

where the drift in the physical time scale l(s), the drift in the intrinsic time scale q(s) and the volatility r(s) are
generally assumed to be constant. The appeal of processes subordinated to a standard Wiener process W by an
intrinsic time process T with non-negative stationary independent increments is also due to the option pricing
formula which follows from the classical Black–Scholes one in a frictionless complete market and from a risk
minimizing strategy in incomplete markets.2 Hurst et al.’s stable subordinated model (1999) uses the unique
continuous martingale measure that makes sense in a discrete time setting, but a priori it does not derive from
a risk minimizing strategy even if the markets are incomplete (see Rachev and Mittnik, 2000). Typically, the
value at time t0 of a European call option with exercise price K and time to maturity t is given by
     
Sðt0 Þ Sðt0 Þ
C t ¼ Sðt0 ÞF þ ln  K r;t0 ;t F  ln ; ð1Þ
K r;t0 ;t K r;t0 ;t

1
Hedging strategies in presence of taxes and transaction costs for subordinated processes can be studied adopting arguments similar to
those used for log normal processes (see, among others, Gilster and Lee, 1984; Leland, 1985; Dybvig and Ross, 1986; Ross, 1987).
2
In incomplete markets there exist non-redundant claims carrying an intrinsic risk. In order to evaluate a contingent claim, a risk-
minimizing strategy is often applied (see Hofmann et al., 1982; Follmer and Sondermann, 1986; Follmer and Schweizer, 1989).
 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631 1617
R þ1  
x12y
where F  ðxÞ ¼ U pffi dF Y ðyÞ, U is the cumulative distribution of a standardized normal N(0, 1), FY is the
0 y
cumulative distribution of a random variable
Z t
Y ¼ r2 ðsÞ dT ðsÞ:
t0
 R 
t
K r;t0 ;t ¼ K exp  t0 rðsÞ ds is the discounted exercise price, and the right continuous with left-hand limits
time-dependent function r(t) defines the short term interest rate. In the following, we describe some subordi-
nated models proposed in literature and we compare and analyze their analytical properties. First, recall that
the stationary increment Z(t + s)  Z(t) has mean lZ,s = 0, variance r2Z;s ¼ lT ;s r2 , where r and lT,s are respec-
tively the scale parameter (volatility) and the mean of the increment of the stationary process T when they exist
(see Clark, 1973). The skewness coefficient of Z(t + s)  Z(t) is zero, i.e., our models are symmetric about the
1þr2
zero mean. An important element is that the subordinated models have kurtosis k Z;s ¼ 3 lT ;sT ;s for all s P 0
(where r2T ;s is the variance of the random variable T(t + s)  T(t) when it exists), that is: subordinated models
with intrinsic random time are leptokurtic. Therefore, all the models we consider present heavier tails and
higher peaks around the origin than the normal distribution.

2.1. The Mandelbrot–Taylor model

Mandelbrot and Taylor (1967) assumed that the intrinsic time process T has stationary independent incre-
d
ments T ðt þ sÞ  T ðtÞ ¼ S a2 ðcs2=a ; 1; 0Þ for all s, t P 0, a 2 (0, 2) and c > 0. Here a/2 is the index of stability, csa/2
is the scale parameter, the stable skewness is 1 and the location parameter is zero, that is, T is a maximal pos-
itively skewed a/2 stable Lévy process.3 It can be shown that for a ! 2 the intrinsic time process T asymptot-
ically approaches the physical time which leads us to the log-normal process for Z(t) = W(T(t)). Under
Mandelbrot–Taylor assumptions the subordinated  process
 Z is a symmetric a-stable motion with stationary
pffi
d 1
independent increments Zðt þ sÞ  ZðtÞ ¼ S a ms ; 0; 0 for all s, t > 0, where m ¼ pffiffi r c 1 . If we consider the
a
2ðcos ðpa
4 ÞÞ
a

constant volatility r, then the random variable Y in Eq. (1) is Y = r (T(t)  T(t0)) = kV where k = cr2(t  t0)2/a
2

2a d 1
and V ¼ S a2 ð1; 1; 0Þ. Hence, with c ¼ 2 cos pa 4
, it follows that ZðtÞ ¼ S a ðrta ; 0; 0Þ. Thus, we can estimate the
index of stability a and the volatility r using the maximum likelihood method. Moreover, considering the den-
u
sity function fV of the a/2 stable random variable V, we obtain with the transformation v ¼ ð1uÞ 3 (that implies
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
3 3
u 2 (0, 1) and u ¼ 1 þ  2v1 þ 4v12 þ 27v1 3 þ  2v1  4v12 þ 27v1 3 ), the following expressions for F±(x) (see (1)):
0 1
Z   Z 1 1 u
!
þ1 1
x  2 kv B x  k
2 ð1uÞ3 C u 1 þ 2u
F  ðxÞ ¼ U pffiffiffiffiffi fV ðvÞ dv ¼ U@ qffiffiffiffiffiffiffiffiffiffiffiffiffi AfV 3 4
du:
0 kv 0 k u
3 ð1  uÞ ð1  uÞ
ð1uÞ

Therefore, F±(x) can now be numerically integrated over the finite interval [0, 1] using the extended midpoint
rule (see Press et al., 1992).
The empirical analysis shows that the stable option prices are generally greater than those obtained from
the classical Black–Scholes model because the stable model considers the risk due to the heavy tails, while the
classical Gaussian model does not. Recall that 2for subordinated models we cannot obtain the classical differ-
ential equation rðt0 Þf ¼ rðt0 ÞS of
oS
t
þ ofott þ 12 r2 S 2 ooSf2t . Nevertheless, there exist relations among the Greeks of a
European option f with exercise price K and time to maturity t. Thus, likewise the classical Black–Scholes
model, we can monitor the variation in the derivative price with respect to the parameters which enter into

3
For alternative approaches to option pricing with stable distributions that do not use subordinated processes see McCulloch (1996),
Rachev and Mittnik (2000) and the references therein.
1618 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631

the option formula (i.e. the Greeks). For example, assuming that the log-price process follows the Mandelb-
rot–Taylor’s subordinated model, we obtain the following relation:
r
rðt0 Þf ¼ rðt0 ÞSDf þ Hf þ Kf ;
aðt  t0 Þ

where the volatility r is constant, Df, Hf and Kf are respectively the delta of
oS
t
the theta ofott and the Vega oft
or
of the
option f. In particular, when the option f is a European call, we obtain the following:
  
oC t Sðt0 Þ
delta ¼ Dc ¼ ¼ F þ ln
oS K r;t0 ;t
o2 C t
gamma ¼ Cc ¼ ¼
oS 2
0 0   12 1
Z þ1 ln Sðt0 Þ
þ 1
kv
1 1 B K r;t0 ;t 2
AC
¼ pffiffiffiffiffiffiffiffiffiffi exp @@ pffiffiffiffiffiffiffi AfV ðvÞ dv
Sðt0 Þ 0 2pkv 2kv
  
oC t Sðt0 Þ
theta ¼ Hc ¼ ¼ rðt0 ÞK r;t0 ;t F  ln þ
ot K r;t0 ;t
0 0   12 1
Z þ1 pffiffiffiffiffi ln Sðt0 Þ
þ 1
kv
r cv B @ K r;t0 ;t 2
AC
 Sðt0 Þ a1 pffiffiffiffiffiffi exp @
pffiffiffiffiffiffiffi AfV ðvÞ dv
0 aðt  t0 Þ a
2p 2kv

and
0 0   12 1
Z þ1 1pffiffiffiffiffi ln S
þ 1
kv
oC t ðt  t0 Þ cv
a
B K r;t0 ;t 2
AC
vega ¼ Kc ¼ ¼ Sðt0 Þ pffiffiffiffiffiffi  exp @@ pffiffiffiffiffiffiffi AfV ðvÞ dv:
or 0 2p 2kv

In addition, we shall introduce a new Greek letter: vf ¼ of

oa
. It describes the evolution of contingent claim
prices with respect to the index of stability.4

2.2. The Hyperbolic model

Barndorff-Nielsen (1995) and Eberlein and Keller (1995) considered the subordinated price process
Z(t) = W(T(t)) with an inverse Gaussian process T also referred to as ‘‘Gaussian-Inverse Gaussian’’ (GIG)
process. Moreover, they require the increments T(t + s)  T(t) being stationary and independent. This issue
leads us to a subordinated motion Z termed as ‘‘Hyperbolic Lévy Motion’’. In particular, known
d
T ðt þ sÞ  T ðtÞ ¼ IGða; d; sÞ

4
In the case of the European call we obtain
0 0   
 12 1 pffiffiffi p
2 ln ððtt0 Þ cos ðpa4 ÞÞ
Z þ1 ln Sðt0 Þ
þ 1
kv v 2a tan pa
4
þ a 2
oC t B K r;t0 ;t 2
AC
vc ¼ ¼ Sðt0 Þ exp @@ pffiffiffiffiffiffiffi A pffiffiffi fV ðvÞ dv
oa 0 2kv 2 p
0 0  Sðt Þ  1 0  Sðt Þ  11
Z þ1 ln K r;t0 ;t þ 12 kv ln K r;t0 ;t  12 kv
þ @Sðt0 ÞU @ pffiffiffiffiffi
0 A  K r;t0 ;t U @ pffiffiffiffiffi
0 AA ofV ðvÞ dv:
0 kv kv oa

ofV ðvÞ
Moreover, using Nolan (1997) another expression for oa
can be found.
 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631 1619

for all t, s P 0 and a, d > 0, with density function

( )
2
ds 3 ðax  dsÞ
fT ;s ðxÞ ¼ pffiffiffiffiffiffi x 2 exp  ; x > 0; ð2Þ
2p 2x

and Laplace transform

( rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi!)
2
LT ;s ðhÞ ¼ exp ads 1  1 þ 2 h :
a

The increments of Z have density function

Z 1   
ds 1 2 x2
fZ;s ðxÞ ¼ u2 exp  ðau  dsÞ þ 2 du
2pr0 2u r
 qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
ads 1 a 2
¼ expfadsg qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi K 1 x2 þ ðadsÞ ;
p 2 r
x2 þ ðrdsÞ

where K1(Æ) denotes the modified Bessel function of the third kind with index 1 (see Barndorff-Nielsen, 1977).
Similarly, the cumulative distribution function for the increments of Z is given by

Z ( )  
1 2
ds 32 ðau  dsÞ x
F Z;s ðxÞ ¼ pffiffiffiffiffiffi u exp  U pffiffiffi du;
2p 0 2u r u

and, finally, the characteristic function is

( rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi!)
r2
/Z;s ðhÞ ¼ exp ads 1  1 þ 2 h2 :
a

a ¼ ra and ~
Now, we set ~ d ¼ dr. Then, the density function has the form
 qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
a~
~ ds 1
fZ;s ðxÞ ¼ a~
expf~ ~ x2 þ ð~dsÞ2 ;
dsg qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi K 1 a
p ~ 2
2
x þ ðdsÞ

the distribution function is

Z 1 ( )  
~
ds au  ~
ð~ dsÞ
2
x
32
F Z;s ðxÞ ¼ pffiffiffiffiffiffi u exp  U pffiffiffi du
2p 0 2u u

and the characteristic function is given by

( rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi!)
1
a~
/Z;s ðhÞ ¼ exp ~ ds 1  1 þ 2 h2 :
~
a

Under these assumptions the random variable Y tt0 ¼ r2 ðT ðtÞ  T ðt0 ÞÞ in Eq. (1) is given by (2) assuming
a, and d ¼ ~
a¼~ d. Thus, analogously to the stable model, we can compute the option price (1) considering that
1620 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631
!
R1 x12 u 3  
F  ðxÞ ¼ 0
U pffiffiffiffiffiffiffiffi
u
ð1uÞ
fY ;tt0 u
ð1uÞ3
1þ2u
ð1uÞ4
du. In particular, when the option f is a European call, we obtain the
ð1uÞ3

following Greeks:
  
oC t Sðt0 Þ
delta ¼ Dc ¼ ¼ F þ ln ;
oS K r;t0 ;t 0 0   12 1
2 Z þ1 ln Sðt0 Þ
þ 1
v
o Ct 1 1 B K r;t0 ;t 2
AC
gamma ¼ Cc ¼ 2
¼ pffiffiffiffiffiffiffiffi exp @@ pffiffiffiffiffi AfY ;tt0 ðvÞ dv;
oS Sðt 0 Þ 0 2pv 2v
0 0  Sðt Þ  1
   Z þ1 ln K r;t0 ;t þ 12 y
oC t Sðt0 Þ @Sðt0 ÞU@ 0 A
theta ¼ Hc ¼ ¼ rðt0 ÞK r;t0 ;t F  ln þ p ffiffiffi
ot K r;t0 ;t 0 y
0  Sðt Þ  11
ln K r;t0 ;t  12 y
 K r;t0 ;t U@ p0
ffiffiffi AA ofY ;tt0 ðyÞ dy
y ot

and, we can introduce two new Greek letters: uf ¼ of oa

and wf ¼ of od
. They describe the evolution of the contin-
gent claim prices with respect to a and d. We observe that
0 0  Sðt Þ  1 0  Sðt Þ  11
Z þ1 ln 0
þ 1
y ln K r;t0 ;t  12 y
uc ¼
oC
¼ @Sðt0 ÞU@ K r;t0 ;t
pffiffiffi
2
A  K r;t ;t U@ p0
ffiffiffi AA ofY ;tt0 ðyÞ dy
0
oa 0 y y oa

and
0 0  Sðt Þ  1 0  Sðt Þ  11
Z þ1 ln K r;t0 ;t þ 12 y ln K r;t0 ;t  12 y
wc ¼
oC
¼ @Sðt0 ÞU@ p0
ffiffiffi A  K r;t ;t U@ p0
ffiffiffi AA ofY ;tt0 ðyÞ dy:
0
od 0 y y od

Even in this case, there exist relations among the Greeks of a European option f with exercise price K and time
to maturity t. Thus, we can monitor the variation in the derivative price with respect to the parameters which
enter into the option formula (i.e. the Greeks). For example, assuming that the log-price process follows the
Hyperbolic subordinated model, we obtain the following relation:
d
rðt0 Þf ¼ rðt0 ÞSDf þ Hf  w ;
t  t0 f
oft oft
where the volatility r is constant, Df, Hf and wf are respectively the delta oS
the theta ot
and of
od
of the option f.

2.3. The log Student’s t-model

Praetz (1972) and Blattberg and Gonedes (1974) proposed the asset log-price to be driven by a Student’s t
process. Analytically, these processes are more complex than the previous ones and we restrict our attention to
the case s = 1. In order to obtain a subordinated motion Z which follows a Student’s t process, we must require
d
the intrinsic time process T have increments T ðt þ 1Þ  T ðtÞ ¼ vm2 for all t P 0 where v2m is a chi-square distrib-
m
uted random variable with m degrees of freedom. Hence, the unitary increments of T have density function
m
2m n mo
m
fT ;1 ðxÞ ¼ 2 m
x21 exp  ; x > 0;
C 2 2x
R1
where CðyÞ ¼ 0 uy1 expfugdu is the gamma function. In addition the unitary increments of intrinsic time
process have characteristic function W1(Æ) whose analytic form we omitted because it is enough complex. Then,
the density function of the increments of Z becomes

 mþ1
C mþ12
x2 2
1 x
fZ;1 ðxÞ ¼ pffiffiffiffiffi m 1 þ 2 ¼ fU ;
r pmC 2 rm r r
 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631 1621

d
where fU(Æ) is a density function of a random variable U ¼ tm with Student’s t distribution and m degrees of free-
dom. The subordinated process Z is therefore a Student’s t process with unitary increments Zðt þ 1Þ
d
ZðtÞ ¼ rtm for all t P 0. Once we have estimated the ‘‘one period’’ parameters of returns, we can extend this
analysis considering that the increments T(t + s)  T(t) are defined by the characteristic function
s
Ws ðuÞ ¼ ðW1 ðuÞÞ ; s 2 N; ð3Þ
where W1(Æ) is the characteristic function of T(t + 1)  T(t). Therefore, using the inverse transform theorem we
can estimate the distribution density fT,s(Æ) of T(t0 + s)  T(t0). However, we generally estimate the density
fT,s(Æ) using Montecarlo simulations in order to limit the approximation errors. Then, we can price the contin-
gent claims considering that
0 1
Z 1 1 u
!
Bx  2 ð1uÞ3 C u 1 þ 2u
F  ðxÞ ¼ U@ qffiffiffiffiffiffiffiffiffiffi AfT ;s 3 4
du:
u r2 ð1  uÞ r2 ð1  uÞ
0 3
ð1uÞ

Clearly, under these assumptions, the distribution of Z(t)  Z(t0) (with t = t0 + s) is not Student’s t distributed
for any integer s 5 1. In particular, when the option f is a European call, we obtain the following Greeks:
  
oC t Sðt0 Þ
delta ¼ Dc ¼ ¼ F þ ln ;
oS K r;t0 ;t
0 0   12 1
2 Z þ1 ln Sðt0 Þ
þ 1
y y
o Ct 1 1 B K r;t0 ;t 2
AC
gamma ¼ Cc ¼ 2
¼ pffiffiffiffiffiffiffiffi exp @@ pffiffiffiffiffi AfT ;tt0 2 dy;
oS Sðt0 Þ 0 2
r 2py 2y r
0 0   1
Z þ1 ln KSðtr;t0 Þ;t þ 12 y
oC t 1@
theta ¼ Hc ¼ ¼ Sðt0 ÞU@ p 0
ffiffiffi A
ot 0 r2 y
0  Sðt Þ  11

ln K r;t0 ;t  12 y   
ofT ;tt0 ry2 Sðt0 Þ
K r;t0 ;t U@ 0
pffiffiffi A A dy  rðt 0 ÞK F
r;t0 ;t  ln
y ot K r;t0 ;t

and
oC t
vega ¼ Kc ¼
or
0 0  Sðt Þ  1 0  Sðt Þ  11

Z ln 0
þ 1
y ln K r;t0 ;t  12 y
2 þ1
1@ K r;t0 ;t 2 ofT ;tt0 ry2
¼  Ct þ Sðt0 ÞU@ pffiffiffi A  K r;t0 ;t U @ 0
pffiffiffi A A dy:
r 0 r2 y y or

In addition, we can introduce the new Greek letter: 1f ¼ of ov

. It describes the evolution of the contingent claim
prices with respect to the degree of freedom v, and it has the form
0 0  Sðt Þ  1 0  Sðt Þ  11

Z þ1 ln 0
þ 1
y ln 0
 1
y
oC 1@ K r;t0 ;t 2 K r;t0 ;t 2 ofT ;tt0 ry2
1c ¼ ¼ Sðt 0 ÞU@ pffiffiffi A  K r;t0 ;t U @ pffiffiffi A A dy:
ov 0 r2 y y ov

In this case, the Greeks of a European option f with exercise price K and time to maturity t could be related.
However, we cannot easily describe them, as we have done in the previous subordinated models.

2.4. The Clark model

Clark (1973) proposed the asset price motion to be generated by the process Z subordinated to the Brown-
ian motion W by a log normal intrinsic time process T. The intrinsic time process has unitary increments
d
T ðt þ 1Þ  T ðtÞ ¼ log N ðl; u2 Þ for all t P 0, l 2 R and u > 0, and the density function is given by
 
1 1 1 2
fT ;1 ðxÞ ¼ pffiffiffiffiffiffi x exp  2 ðlogðxÞ  lÞ ; x > 0
u 2p 2u
1622 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631

and the characteristic function W e 1 ðÞ of T(t + 1)  T(t) has the form described by Leipnik (1991). Then,
Z 1 ( "  2 #)
2 2
1 3 1 x logðyÞ  l  logðr Þ
fZ;1 ðxÞ ¼ y 2 exp  þ dy
u2p 0 2 y u

and
Z   ( "  2 #)
1 2 2
1 x 1 x logðyÞ  l  log ðr Þ
F Z;1 ðxÞ ¼ pffiffiffiffiffiffi y 1 U pffiffiffi exp  þ dy:
u 2p 0 y 2 y u

Now, by setting l~ ¼ l þ logðr2 Þ we have:

Z 1 ( "  2 #)
1 32 1 x2 logðyÞ  l
~
fZ;1 ðxÞ ¼ y exp  þ dy;
u2p 0 2 y u

and
Z ( "  2 #)  
1
1 1 1 x2 logðyÞ  l
~ x
F Z;1 ðxÞ ¼ pffiffiffiffiffiffi y exp  þ U pffiffiffi dy:
u 2p 0 2 y u y

d pffiffiffiffi d d
Therefore, Zðt þ 1Þ  ZðtÞ ¼ GW , with W ¼ N ð0; r2 Þ and G ¼ log N ðl; u2 Þ or equivalently, when re-parame-
d d
terized W ¼ N ð0; 1Þ and G ¼ log N ð~l; u2 Þ. Then, we extend this analysis considering that the increments
2
r ( T(t + s)  T(t)) are defined by the characteristic function
s
Ws ðuÞ ¼ ðW1 ðuÞÞ ; s 2 N; ð4Þ
2
where W1(Æ) is the characteristic function of r (T(t + 1)  T(t)) (see Leipnik, 1991). Therefore, using the in-
verse transform theorem we can estimate the distribution density fY,s(Æ) of r2(T(t)  T(t0)) (with t = t0 + s).
Then, we can price the contingent claims considering that
0 1
Z 1 1 u
!
B x  2 ð1uÞ3 C u 1 þ 2u
F  ðxÞ ¼ U@ qffiffiffiffiffiffiffiffiffiffi AfY ;tt0 3 4
du:
u ð1  uÞ ð1  uÞ
0 3
ð1uÞ

In particular, when the option f is a European call, we obtain the following Greeks:
  
oC t Sðt0 Þ
delta ¼ Dc ¼ ¼ F þ ln ;
oS K r;t0 ;t
0 0   12 1
2 Z þ1 ln Sðt0 Þ
þ 1
y
o Ct 1 1 B K r;t0 ;t 2
AC
gamma ¼ Cc ¼ 2
¼ pffiffiffiffiffiffiffiffi exp @@ pffiffiffiffiffi AfY ;tt0 ðyÞdy;
oS Sðt0 Þ 0 2py 2y
  
oC t Sðt0 Þ
theta ¼ Hc ¼ ¼ rðt0 ÞK r;t0 ;t F  ln
ot K r;t0 ;t
0 0  Sðt Þ  1 0  Sðt Þ  11
Z þ1 ln K r;t0 ;t þ 12 y ln K r;t0 ;t  12 y
þ @Sðt0 ÞU@ p 0
ffiffiffi A  K r;t ;t U@ p0
ffiffiffi AA ofY ;tt0 ðyÞ dy
0
0 y y ot

and, we can introduce two new Greek letters: /f ¼ of o~

l
and nf ¼ ou of
. They describe the evolution of the contin-
gent claim prices with respect to l
~, and u. We observe that
0 0  Sðt Þ  1 0  Sðt Þ  11
Z þ1 ln 0
þ 1
y ln K r;t0 ;t  12 y
/c ¼
oC
¼ @Sðt0 ÞU@ K r;t0 ;t
pffiffiffi
2
A  K r;t ;t U@ p0
ffiffiffi AA ofY ;tt0 ðyÞ dy
0
o~
l 0 y y o~
l
 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631 1623

and
0 0  Sðt Þ  1 0  Sðt Þ  11
Z þ1 ln K r;t0 ;t þ 12 y ln K r;t0 ;t  12 y
nc ¼
oC
¼ @Sðt0 ÞU@ p0
ffiffiffi A  K r;t ;t U@ p0
ffiffiffi AA ofY ;tt0 ðyÞ dy:
0
ou 0 y y ou

In this case, there exist relations among the Greeks of a European option f with exercise price K and time to
maturity t, even if it is not so simple to describe their relations that will be object of future researches.

2.5. The log-Laplace model

Finally, we describe the log-Laplace model (Mittnik and Rachev, 1993) where we suppose that the asset log
d
price is driven by a symmetric Laplace motion. Then, T ðt þ 1Þ  T ðtÞ ¼ expðkÞ for all t P 0 and k > 0, with fT,1
k
(x) = kexp{kx} x > 0 and Laplace transform LT ;1 ðcÞ ¼ kþc for c P 0. The density function of a unit incre-
ments of Z is
Z 1   pffiffiffi ( pffiffiffiffiffi )
k 1 x2 k 2k
fZ;1 ðxÞ ¼ pffiffiffiffiffiffi pffiffiffi exp  2  ku du ¼ pffiffiffi exp  jxj ; x 2 R:
r 2p 0 u 2r u r 2 r

The distribution function is

( pffiffiffiffiffi) ( pffiffiffiffiffi)!
1 2k 1 2k
F Z;1 ðxÞ ¼ exp x vfx<0g ðxÞ þ 1  exp x vfxP0g ðxÞ;
2 r 2 r

where vA(Æ) is the indicator function of the set A, and the characteristic function is given by
 1
1
/Z;1 ðhÞ ¼ 1 þ r2 h2 ; h 2 R:
2

~ ¼ prffiffiffi
Finally, with the re-parameterization r 2k
ffi we write
 
1 jxj
fZ;1 ðxÞ ¼ exp 
2~
r r
~

and
nxo  n x o
1 1
F Z;1 ðxÞ ¼ exp v ðxÞ þ 1  exp  vfxP0g ðxÞ:
2 ~ fx<0g
r 2 r
~

When we consider stationary and independent increments T(t + s)  T(t) for every s P 0 we obtain that they
follow a Gamma distribution with density
ks s1
fT ;s ðxÞ ¼ x expfkxg:
CðsÞ

Thus Y tt0 ¼ r2 ðT ðtÞ  T ðt0 ÞÞ admits density distribution

 x tt0 1  
ktt0 kx
fY ;tt0 ðxÞ ¼ 2 exp  :
r Cðt  t0 Þ r2 r2

Thus, analogously to the previous model, we can compute the option price (1) considering that
!
R1 x12 u 3  
F  ðxÞ ¼ 0 U pffiffiffiffiffiffiffiffi
ð1uÞ
u
u
fY ;tt0 ð1uÞ 3
1þ2u
ð1uÞ4
du. In particular, when the option f is an European call, we obtain
ð1uÞ3

the following Greeks:

1624 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631
  
oC t Sðt0 Þ
delta ¼ Dc ¼ ¼ F þ ln ;
oS K r;t0 ;t
0 0   12 1
2 Z þ1 ln Sðt0 Þ
þ 1
v
o Ct 1 1 B K r;t0 ;t 2
AC
gamma ¼ Cc ¼ 2
¼ pffiffiffiffiffiffiffiffi exp @@ pffiffiffiffiffi AfY ;tt0 ðvÞ dv;
oS Sðt0 Þ 0 2pv 2v
  
oC t Sðt0 Þ
theta ¼ Hc ¼ ¼ rðt0 ÞK r;t0 ;t F  ln
ot K r;t0 ;t
0 0  Sðt Þ  1 0  Sðt Þ  11
Z þ1 ln K r;t0 ;t þ 12 y ln K r;t0 ;t  12 y
þ @Sðt0 ÞU@ p0
ffiffiffi A  K r;t ;t U@ p0
ffiffiffi AA ofY ;tt0 ðyÞ dy
0
0 y y ot

and, we can introduce the Greek letter -f ¼ of ok

. This describes the evolution of the contingent claim prices with
respect to k. We observe that
0 0  Sðt Þ  1 0  Sðt Þ  11
Z þ1 ln 0
þ 1
y ln 0
 1
y
-c ðtÞ ¼
oC t
¼ @Sðt0 ÞU@ K r;t0 ;t
pffiffiffi
2
A  K r;t ;t U@ K r;t0 ;t
pffiffiffi
2
AA ofY ;tt0 ðyÞ dy:
0
ok 0 y y ok

In particular, for every contingent claim ft (valued at time t) we obtain that:

k
ft ¼ ft1  -f ðt  1Þ:
ðt  t0  1Þ

3. A comparison among delta hedging strategies

In this section we compare different hedging strategies obtained using either subordinated models or the
Black–Scholes model.
We use the Maximum Likelihood Estimation (MLE) to estimate the parameters of the subordinated asset
price models. Our data consist of S&P 500 daily (weekly) returns from January 1, 1995 to January 31, 1998
(see Table 1). From a preliminary analysis of our data we observe that daily and weekly returns are negatively
skewed and present kurtosis significantly different from the Gaussian one. Observe that not all the above sub-
ordinated models are Lévy processes. Therefore, from a daily distributional assumption we can generally
derive a corresponding weekly subordinated model that could be different from that obtained assuming an
analogous distributional assumption on weekly returns. In order to verify which distributional hypothesis

Table 1
S&P 500 parameters of subordinated models
Model Daily Weekly
Black–Scholes ^ ¼ 0:0083
r ^ ¼ 0:018559
r
Stable ^ ¼ 0:012087
r ^ ¼ 0; 031062
r
a^ ¼ 1:7052 a^ ¼ 1:7052
Student ^m ¼ 3:8447 ^m ¼ 11:158
^ ¼ 0:0085
r ^ ¼ 0:01448
r
Laplace ^ ¼ 0:13286
r ^ ¼ 0:0999
r
^k ¼ 116:101 ^k ¼ 32:034

Clark ^ ¼ 1:172
u ^ ¼ 1:1079
u
^ ¼ 10:164
l ^ ¼ 9:224
l
Hyperbolic ^a ¼ 105:235 ^a ¼ 89:327
d^ ¼ 0:0065741 d^ ¼ 0:02165
 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631 1625

approximates better the S&P 500 return series, we propose two tests which are based on the whole empirical
distribution. We consider the Kolmogorov–Smirnov (K–S) test
sup jF E ðxÞ  F ðxÞj
x2R

and the Anderson–Darling (A–D) statistic test

jF E ðxÞ  F ðxÞj
sup pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ;
x2R ð1  F ðxÞÞF ðxÞ
where FE(x) is the empirical cumulative distribution and F(x) is the other distribution. The A–D statistic test
weights discrepancies appropriately across the whole support of the distribution and it is particularly impor-
tant if one is interested in determining tails of return distributions. Therefore, we could compare the empirical
cumulative distribution FE(x) of several portfolio residuals with either a simulated Gaussian or a non-Gauss-
ian distribution F(x). The proposed tests agree upon rejecting the hypothesis of normality. In Table 2 we re-
port the results of the two tests saying that the non-Gaussian distributions approximate better the S&P 500
return series than the Gaussian one. In addition, we obtain a better fit for daily subordinated models respect
to weekly one. This implies that we obtain a better fit for weekly subordinated models derived from the daily
one respect to the weekly models obtained assuming the maximum likelihood estimation of weekly data (see
Table 2). For this reason, in the following analysis we always use the subordinated models derived from the
daily distributional assumptions.
Next, we describe the dynamic hedging scheme applied to the S&P 500 under various distributional hypoth-
eses. In particular, each day of the period 30/06/97–31/10/97, we study the ex-post effects of different delta
hedging strategies assuming short positions in European calls on 10,000 shares of the S&P 500. Thus, we
examine the problem of hedging the exposure of these positions. Specifically, we distinguish and analyze
the final hedging costs and the effective costs of each delta hedging strategy. Recall that the final hedging cost
of a call option is given by
cumulative cost  exercise price if K i < S T ðin-the-moneyÞ
Hedging cost ¼ ;
cumulative cost if K i > S T ðout-the-moneyÞ
while the effective cost of the delta hedging strategy is
Effective cost ¼ discounted hedging cost  option price:
The hedging cost is the cost of doing hedging independently of the option price evaluated by the traders, while
the effective cost represents the real loss of a given strategy considering a particular model to estimate the op-
tions. We distinguish the two costs because a given delta hedging strategy could be more convenient than oth-
ers independently of the initial option price paid.
In order to explain our comparison of different hedging strategies, we give the following example.
Example. The S&P 500 quoted at 914.62$ on 31/10/97. We estimate the parameters of the models using daily
data from 1/3/95 to 30/06/97. For the Black–Scholes model we obtain a weekly volatility: r = 0.018559, and

Table 2
Kolmogorov–Smirnov test and Anderson–Darling test for S&P 500 return series
Daily Weekly using MLE of weekly data Weekly derived from daily
subordinated models
Kolmogorov Anderson and Kolmogorov Anderson and Kolmogorov Anderson and
Darling Darling Darling
Laplace 0.12388 0.28581 0.18039 0.36675 0.17463 0.36444
Clark 0.09021 0.18043 0.21155 0.49626 0.15145 0.30300
Student 0.13741 0.30142 0.15956 0.45216 0.14343 0.35706
Black & Scholes 0.11879 594582.94799 0.3421 11.639 0.3421 11.639
Stable 0.23523 0.50347 0.2551 0.543 0.2551 0.543
Hyperbolic 0.09040 0.37366 0.16509 0.36169 0.15112 0.35277
1626 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631

for the stable subordinated model we have: r = 0.031062 and a = 1.7052. We assume that the time to maturity
is 13 weeks and we consider a 6% p.a. risk free rate.
We compare the effective and the delta hedging strategies costs with the Stable or Gaussian models using
the ex-post daily prices of S&P 500 and assuming several exercise prices. For example, if we apply a weekly
dynamic delta hedging strategy considering an exercise price 970$, that is, the option closes in-the-money, we
obtain Table 3 for the Black–Scholes model and for the stable subordinated model. Table 3 reports that the
cost of the stable delta hedging strategy (that is equal to the ‘‘cumulative cost’’  ‘‘exercise price’’ =
$9,991,974  $9,700,000) will be lower than the cost of the Black–Scholes one at the end of the period, even if
the stable call price is greater than the Black–Scholes call price. Therefore, the effective cost of the Black–
Scholes model is much greater than the Stable one and this may not be a unique case. In fact, in Table 4 we see
that generally the stable delta hedging strategy is less expensive than the Gaussian one considering daily or
weekly hedging strategies. We obtain similar results changing the maturity and the riskless return.

Analogously to the above example, we extend our ex-post analysis to the other models considering daily
and weekly delta hedging strategies. Every day from 30/06/97 to 31/10/97, we assume a short position on a
three months European call option on 10,000 shares of the S&P 500 with risk free rate 6% p.a. (daily rate
r ¼ 0:06
252
). Therefore, we consider 100 European call options and we vary the exercise prices Ki(t) at time t (with

Table 3
Scheme of weekly delta hedging strategies (with both the Black and Scholes model and the stable subordinated model) considering an
excercise price of 970$, that is option closes in the money
Data S&P 500 price Delta Shares purchased Cost of shares Cumulative costs Interests cost
purchased (incl. interests)
The Black and Scholes model
31/10/97 914.62 0.267333 2673.33317 2445084 2445083.981 2821.251
07/11/97 927.51 0.326644 593.110201 550115.6 2998020.874 3459.255
14/11/97 928.35 0.317034 96.1035245 89217.7 2912262.422 3360.303
21/11/97 963.09 0.541468 2244.33858 2161500 5077122.772 5858.219
28/11/97 955.4 0.47686 646.079099 617264 4465717.018 5152.75
05/12/97 983.79 0.681182 2043.22229 2010102 6480971.426 7478.044
12/12/97 953.39 0.435374 2458.07943 2343508 4144941.125 4782.624
19/12/97 946.78 0.360189 751.849126 711836 3437888.034 3966.794
26/12/97 936.46 0.245674 1145.1539 1072391 2369464.009 2733.997
02/01/98 975.04 0.611227 3655.52848 3564286 5936484.493 6849.79
09/01/98 927.69 0.103182 5080.4462 4713079 1230255.15 1419.525
16/01/98 961.51 0.407534 3043.51974 2926375 4158049.342 4797.749
23/01/98 957.59 0.266858 1406.75977 1347099 2815748.004 3248.94
30/01/98 980.28 1 7331.41858 7186843 10005839.95 0
Cost of hedging 305839.9489

The stable subordinated model

31/10/97 914.62 0.23985 2398.50231 2193718 2193718.178 2531.213
07/11/97 927.51 0.287018 471.681937 437489.7 2633739.105 3038.93
14/11/97 928.35 0.280085 69.3327945 64365.1 2572412.935 2968.169
21/11/97 963.09 0.47221 1921.25012 1850337 4425717.877 5106.598
28/11/97 955.4 0.417348 548.618415 524150 3906674.441 4507.701
05/12/97 983.79 0.61034 1929.91685 1898633 5809815.036 6703.633
12/12/97 953.39 0.385247 2250.9281 2146012 3670506.33 4235.2
19/12/97 946.78 0.320851 643.959297 609688 3065053.746 3536.6
26/12/97 936.46 0.223122 977.287915 915191 2153399.306 2484.692
02/01/98 975.04 0.563066 3399.43762 3314588 5470471.654 6312.083
09/01/98 927.69 0.102598 4604.6864 4271722 1205062.215 1390.456
16/01/98 961.51 0.371473 2688.75102 2585261 3791713.667 4375.054
23/01/98 957.59 0.231663 1398.09675 1338803 2457285.25 2835.329
30/01/98 980.28 1 7683.36982 7531854 9991974.35 0
Cost of hedging 291974.3495
 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631 1627

Table 4
Effective costs and costs of dynamic weekly and daily delta hedging strategies considering the Black and Scholes model and the stable
subordinated model
Exercise price Weekly Daily
(in the money)
Stable cost of hedging Gaussian cost of hedging Stable cost of hedging Gaussian cost of hedging
960 359071.6 359593.7 246823.4 247164.8
965 329872 336618.7 224474.8 228252.9
970 292003.4 305872.5 197612.4 206062.2
975 245330 266806 166028. 4 177336.9
980 191001.5 219696.6 123725. 6 138084.5
Exercise price
(out the money)
985 178114.8 212738.9 112821 133990.2
990 164301 202988.8 95176.28 123810.6
995 148516.8 189264.7 78558.6 110125.3
1000 132091.1 173099 65378.78 96486.66
1005 115940.7 155784.4 54328.7 1 83862.53

Weekly Daily
Exercise price Stable effective cost Gaussian effective cost Stable effective cost Gaussian effective cost
(in the money)
960 149058.9 231079.6 39452.1 152387.9
965 135043.3 222424.3 31215.3 134605.4
970 111354.1 204851 18368.4 113852.2
975 77915.7 177886.9 205.27 90101.23
980 35921.17 141875.5 30353 63381.18
Exercise price
(out the money)
985 33797.82 144366.2 30524 80270.71
990 29869.32 143127.2 38226 65127.78
995 23169.26 137067.1 45747 59105.99
1000 15066.89 127767.5 50652 52295.8
1005 6523.959 116571.9 54171 45720.78

t varying among maturities from 30/06/97 till 31/10/97 and i = 1, . . . , 10 that points out the ith exercise price).
In particular, for each call option, we assume five prices in-the-money and five prices out-the-money maintain-
ing constant the (ex-post) known difference S(t)  Ki(t) for every t = 1, . . . , 100 and for every i = 1, . . . , 10.
Then, we proceed with our empirical comparison.
First of all, we study if the hedging strategies are effective. We analyze if at each ‘‘hedging time’’ tk the hedg-
ing strategy forecasts correctly the exposure position and
Sðtk Þð1  Dðtk1 ÞÞ  K i 6 0
for every exercise price Ki and every call option. Table 5 reports the percentages of the hedged positions. Gen-
erally, almost all models hedge the exposures of the option positions correctly, even if the Black–Scholes,

Table 5
Percentages of hedged positions
Daily Weekly
Laplace 1 1
Clark 1 0.99983
Student 1 1
Black and Scholes 0.99986 1
Stable 1 1
Hyperbolic 0.99991 1
1628 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631

Table 6
Average of call prices
Cardinality of Black and Scholes Stable Student Laplace Clark Hyperbolic
exercise price
In the money 1 338859.7 423991.1 439532.6 447710.7 347496.7 328270.1
2 312394.3 398035.0 414122.9 422217.1 321104.6 301668.7
3 287313.4 373305.8 389727.6 397723.0 296064.9 276511.4
4 263612.0 349798.4 366341.7 374223.0 272372.8 252793.3
5 241278.4 327502.7 343957.0 351709.4 250016.7 230501.9
Out the money 6 220294.6 306403.4 322563.0 330171.8 228979.5 209617.6
7 200636.8 286480.3 302146.8 309597.8 209238.1 190113.9
8 182275.5 267709.2 282693.1 289972.7 190764.3 171958.1
9 165176.1 250061.3 264184.5 271279.9 173524.9 155111.8
10 149299.5 233504.6 246601.5 253500.9 157482.6 139531.5

Clark and Hyperbolic models sometimes fail. This table implicitly underlines the limits of these models to pre-
dict the heavy tails of distributions.
In Tables 6 we report the average of option prices which are almost equal (at less of an approximation) for
both daily and weekly strategies. Therefore, we report the mean of the 100 call option prices on 10,000 shares
of the S&P 500 for every exercise price Ki. That is, we compute the mean among 100 prices for every exercise
price Ki and for every distributional hypothesis. This table gives an idea of the highest and the smallest option
prices considering different distributional hypotheses. According to the idea that option prices in incomplete
markets are higher than those obtained for complete markets, we observe that almost all the subordinated
models, except the Hyperbolic one, present greater European call prices than the Black and Scholes model.

3.1. Daily delta hedging strategies

In Tables 7 and 8 we report respectively the average of: hedging costs and effective costs; of daily delta
hedging strategies.
Table 7 reports the mean of the hedging costs considering daily strategies. Thus, we compute the mean
among the 100 call options of the final hedging costs. We observe that the hedging costs of the subordinated
models are always lower than those of the Black and Scholes except for the Hyperbolic model. Thus, indepen-
dently of the option price we apply, it is generally more convenient using daily delta hedging strategies with
subordinated models with respect to those of the Black and Scholes one. The best performance of the hedging
costs are given from the Laplace and log-Student model that forecasts correctly the exposure position. Besides,
considering the mean of the 100 call options of effective costs (see Table 8) we observe that the effective costs of
subordinated delta hedging strategies are always lower than the Black–Scholes ones except for the Hyperbolic

Table 7
Average heading costs (daily strategies)
Cardinality of Black and Scholes Stable Student Laplace Clark Hyperbolic
exercise price
In the money 1 618968.6 593699.0 527871.1 518681.2 598397.9 626083.5
2 589403.5 564667.3 493664.4 483084.9 560458.5 590526.5
3 553800.8 530202.1 455190.7 443491.3 515840.6 547353.7
4 509108.9 486890.5 410721.8 398516.1 463871.9 495680.9
5 452769.5 431418.1 359009.8 347183.9 404378.9 435227.1
Out the money 6 431513.4 410074.0 347052.2 336556.5 385090.5 413,723.8
7 403218.8 381274.3 331464.8 323063.2 362839.0 388120.0
8 369122.5 347211.5 311352.3 305445.9 336516.7 357566.6
9 333218.4 312186.9 288911.4 285492.9 307966.3 324328.2
10 298254.3 278955.9 266066.0 264800.7 278906.6 290639.1
 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631 1629

Table 8
Average effective costs (daily strategies)
Cardinality of Black and Scholes Stable Student Laplace Clark Hyperbolic
exercise price
In the money 1 270527.9 160518.0 80167.6 62941.9 241638.6 288122.3
2 267885.8 157891.8 71900.1 53390.1 230678.7 279717.1
3 257915.1 148689.3 58417.1 38903.5 211791.0 262369.8
4 237616.5 129555.5 38022.5 18124.4 184318.9 235215.0
5 204482.8 97237.5 9495.7 9899.5 148102.8 197988.4
Out the money 6 204539.4 97323.2 19117.1 1175.2 150150.2 197702.2
7 196340.6 88892.2 24187.3 8464.7 147984.5 191998.4
8 181133.4 74127.8 23839.8 10745.2 140543.5 180073.7
9 162884.4 57293.3 20254.9 9793.9 129674.4 164196.1
10 144338.1 41133.4 15346.2 7200.9 117106.9 146608.8

model. In particular, the effective cost of a subordinated hedging strategy could be lower than zero (see Table
8). Furthermore being the market incomplete, we do not have a perfect hedge. In according to better fits, the
Laplace, log-Student and Stable subordinated models present effective costs significantly lower than the
Gaussian model.

3.2. Weekly delta hedging strategies

When we consider delta hedging strategies with lower frequency (weekly) generally we obtain similar results
at our previous analysis. Tables 9 and 10 report respectively the average of: hedging costs and effective costs of
weekly delta hedging strategies.
In terms of the hedging costs of weekly hedging strategies we observe that those obtained with the Laplace
model are the lowest even if almost all the other models present lower hedging costs than those obtained with
the Black & Scholes (see Table 9). Finally, in terms of the effective costs of weekly hedging strategies, we see
that Laplace, log-Student and Stable subordinated models present significative lower effective costs, while the
effective costs obtained with the Clark and Hyperbolic models do not differ sensibly from those of the Black
and Scholes model (see Table 10).
This analysis underlines the limits of the Black–Scholes model. The best approximation of the Laplace, Stu-
dent, Stable and Clark subordinated models reduces the costs and the effective costs of the classical hedging
strategies. Thus, it is better to apply a delta hedging strategy using a subordinated model and, in particular the
Laplace one. Indeed, further ex-post studies and comparisons would be necessary to confirm these results.
Nevertheless, the more protective behavior of the Stable, Laplace and Student option pricing formulas leads
us to reject the classical log-normal hypothesis and to propose alternative subordinated models of asset prices.

Table 9
Average heading costs (weekly strategies)
Cardinality of Black and Scholes Stable Student Laplace Clark Hyperbolic
exercise price
In the money 1 475184.8 457470.7 409533.6 404035.6 472758.7 487456.5
2 440759.3 423051.4 370536.0 364339.8 438605.5 457940.3
3 401582.6 383819.0 328794.3 322151.7 399472.2 420474.4
4 357193.8 339297.1 284025.3 277226.0 354909.7 374575.9
5 307486.4 289412.5 236121.3 229462.6 304856.0 320426.6
Out the money 6 299896.2 281670.3 232348.4 226107.0 296806.0 305,960.3
7 290547.1 272288.6 228526.7 222935.4 286963.2 287966.1
8 277368.9 259299.9 222194.6 217428.4 273358.1 265153.8
9 261204.4 243631.2 213767.1 209936.9 256930.1 239145.6
10 242922.2 226189.7 203694.1 200848.3 238606.2 211455.9
1630 D. De Giovanni et al. / European Journal of Operational Research 185 (2008) 1615–1631

Table 10
Average effective costs (weekly strategies)
Cardinality of Black and Scholes Stable Student Laplace Clark Hyperbolic
exercise price
In the money 1 132270.2 29612.7 33209.8 46795.2 121233.7 175078.2
2 124682.8 21539.3 46316.0 60503.6 113844.8 145605.5
3 111029.0 7496.6 63140.7 77667.4 100196.1 114565.0
4 90860.6 12979.2 83957.2 98522.6 79850.9 93489.5
5 64085.2 39949.5 108,863.6 123159.7 52760.4 75578.3
Out the money 6 77450.9 26600.4 91286.3 105026.0 65730.2 69083.7
7 87759.6 16041.4 74734.5 87674.2 75639.6 70480.9
8 93001.9 10185.8 61617.3 73571.3 80577.3 55551.1
9 94043.4 8091.3 51508.4 62354.6 81502.2 42953.3
10 91779.3 8831.6 43944.8 53623.8 79365.8 32247.5

4. Conclusions

The paper analyzes and compares option pricing models. In particular, we review option pricing models for
subordinated return distributions. We compare dynamic hedging strategies obtained with the classical Black–
Scholes model and with several subordinated models. In order to evaluate the impact of different distribu-
tional hypotheses on the hedging costs, we propose an ex- post analysis on the S&P 500 series.
Considering different exercise prices we observe that the effective and hedging costs are lower for the sub-
ordinated models with respect to the Black–Scholes one, specifically when we consider delta hedging strategies
with higher frequency. Even if all models forecast the exposure positions well enough, we observe that the
Laplace model, the Student model and the Stable model present the best performance among all the models
considered.

Acknowledgements

The authors thank for helpful comments seminar audiences at EWGFM 2004 (Paris) and at AMASES 2004
(Modena). S. Rachev’s research was supported by grants from Division of Mathematical, Life and Physical
Sciences, College of Letters and Science, University of California, Santa Barbara and the Deutschen Fors-
chungsgemeinschaft. Ortobelli’s research has been partially supported under Murst 40%, 60%, 2002, 2003,
2005, 2006 and CNR-MIUR-Legge 95/95.

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