Physica A xx (xxxx) xxx–xxx

Contents lists available at ScienceDirect

Physica A
journal homepage: www.elsevier.com/locate/physa

Option pricing and portfolio hedging under the mixed

hedging strategy✩
Q1 Xiao-Tian Wang ∗ , Zhong-Feng Zhao, Xiao-Fen Fang
Department of Mathematics, South China University of Technology, Guangzhou, 510640, Guangdong, PR China

highlights
• We have proposed a mixed hedging strategy to price options.
• Risk preference parameter µ and scaling δ t have the important influences on the effective cost.
• We get that the mixed hedging strategy is better than the delta hedging in some cases.
• The relation between scaling and portfolio hedging is discussed.

article info abstract

Article history: This paper is concerned in the option pricing and portfolio hedging in a discrete time
Received 22 May 2014 incomplete market. It has been shown that scaling and residual risks as well as the mixed
Received in revised form 16 September hedging strategy play an important role in option pricing and portfolio hedging in a discrete
2014
time case. In particular, the relation between scaling (i.e., trading frequency) and portfolio
Available online xxxx
hedging is discussed.
© 2015 Published by Elsevier B.V.
Keywords:
Residual risk
Scaling
Option pricing
Portfolio hedging
Trade frequency
Mixed hedging strategy

1. Introduction 1

Over the last few years, the financial markets are regarded as complex and nonlinear dynamic systems. A series of studies 2

have found that many financial market time series display scaling laws and long-range dependence [1–8]. Therefore, it has 3

been suggested that one should consider the influence of the scaling laws and the trading frequency on option pricing 4

and portfolio hedging [1–8]. The interest in option pricing has dramatically increased since the publication of the works of 5

Black and Scholes [9] and Merton [10]. An essential feature of their approaches is that the trading is assumed to make in a 6

continuous-time manner so that the price of any option does not depend on the time scaling and investors’ risk preferences 7

(scaling-free pricing and preference-free pricing). However, it is well known that continuous trading is an abstraction, which 8

is physically impossible in actual markets. In practice, the investors revise the option risk from time to time and make the 9

revisions be in accordance with the Black–Scholes–Merton prescription. But as far as Black–Scholes model is concerned 10

without the continuous time trading assumption, the market is no longer complete, therefore the option price cannot be 11

✩ This work is supported by the National Natural Science Foundation of China (Nos. 11071082, 11271140).
∗ Corresponding author.
E-mail address: swa001@126.com (X.-T. Wang).

http://dx.doi.org/10.1016/j.physa.2015.01.021
0378-4371/© 2015 Published by Elsevier B.V.
 2 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx

1 determined by the no-arbitrage argument alone. In fact, as it will be shown in this paper, that the trading frequency and the
2 trade scaling (i.e., the spacing between consecutive financial transaction) as well as the residual risk play an important role
3 in option pricing and portfolio hedging.
4 The problem of hedging the option and portfolio in an incomplete market in a discrete time trade case has been
5 studied by many authors starting with Boyle and Emanuel [11], Leland [12], and Wilmott [13,14] up to more recent works
6 [15–20]. Many econophysicists are interested in analyzing financial time series through using different time scaling δ t from
7 hourly through daily to weekly and monthly, then compare and interrelate the results within the same study. In particular,
8 Mantegna and Stanley [1–4] introduced the method of scaling invariance from complex science into economic systems for
9 the first time. Since then, a lot of research on scaling laws in finance has taken place. Mandelbrot [5,6] and Mantegna and
10 Stanley [1,2] considered the problem of choosing the appropriate time scaling to use for analyzing financial market data
11 and pricing option. Bouchaud and Potters et al. [7,8] made a discussion on the relation between continuous-time trade and
12 discrete-time trade in option pricing and introduced an asymptotic approach allowing one to tackle the residual risk as well
13 as proposed to find the optimal strategies that minimize the hedging error. In this paper, on basis of the points of view of
14 econophysics [1,2,5–8], we will propose a mixed hedging strategy to price the option.
15 This paper is organized as follows. In Section 2, a mixed hedging strategy for option pricing is obtained, and we show
16 that the residual risk and trade scaling play an important role in the Black–Scholes option pricing model. In Section 3 some
17 examples are given to show that the generalization of the delta hedging strategy X1 (t ) (i.e., mixed hedging strategy) is an
18 improvement over the Black–Scholes delta hedging in some cases. Section 4 concludes.

19 2. Option pricing under the mixed hedging strategy

20 In this section a mixed hedging strategy is given, and we show that the trading frequency and the scaling (i.e., the spacing
21 between consecutive financial transaction) as well as the residual risk play an important role in the Black–Scholes case while
22 the continuous time trading assumption is given up.
23 Consider a simple financial market model with constant coefficients, which consists of a stock and a bond with price
24 dynamics given by

25 St = S0 eµt +σ Bt , (2.1)

26 and

27 Dt = D0 ert , (2.2)

28 where µ, σ ̸= 0, S0 > 0, r > 0, t ∈ [0, T ], T ∈ R fixed, and {Bt }t ∈[0,T ] a standard one dimensional Brownian motion
29 on a complete probability space (Ω , Ft , P ) which is equipped with the P-augmentation {Ft }t ∈[0,T ] of the natural Brownian
30 filtration.
31 After a small time interval δ t, the price changes in the bond and in the stock are

δ Dt = rDt δ t + O (δ t )2 ,
 
32 (2.3)

σ2
 
δ St = St eµδt +σ δBt − 1 = St µδ t + σ (1 + µδ t ) δ Bt + (δ Bt )2 + G1 (δ t ) ,
 
33 (2.4)
2
34 and

σ 2 δt
 
35 E [δ St ] = St µδ t + + E [G1 (δ t )]. (2.5)
2
36 On the other hand, since

E [δ St ] = St E eµδ t +σ δ Bt − 1
 
37

σ2
38 = St [e(µ+ 2 )δt − 1]
σ 2δt
 
= St µδ t + + O (δ t )2 ,
 
39 (2.6)
2
40 substituting Eq. (2.5) into Eq. (2.6) we get that

E [G1 (δ t )] = O (δ t )2 .
 
41 (2.7)

42 From the Taylor formula, we get that

43 (δ St )2 = St2 [eµδt +σ δBt − 1]2

44 = St2 [e2µδt +2σ δBt − 2eµδt +σ δBt + 1]
 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx 3

(2µδ t + 2σ δ Bt )2  ∞
(2µδ t + 2σ δ Bt )k
= St2 2 + 2(µδ t + σ δ Bt ) + + 1
2! k=3
k!

2(µδ t + σ δ Bt )k
∞
− 2 − 2(µδ t + σ δ Bt ) − (µδ t + σ δ Bt ) −
2
2

k=3
k!
 
∞
(2µδ t + 2σ δ Bt )k  ∞
2(µδ t + σ δ Bt )k
= St (µδ t + σ δ Bt ) +
2 2
− 3

k=3
k! k=3
k!
 
 ∞
(2µδ t + 2σ δ Bt )k  ∞
2(µδ t + σ δ Bt )k
= St σ (δ Bt ) + 2µσ δ t δ Bt + (µδ t ) +
2 2 2 2
− 4

k=3
k! k=3
k!

= St2 [σ 2 (δ Bt )2 + 2µσ δ t δ Bt ] + G2 (δ t ), (2.8) 5

 ∞ (2µδt +2σ δBt )k ∞ 
2(µδ t +σ δ Bt )k
where G2 (δ t ) = St2 (µδ t )2 + k=3 k!
− k=3 k!
. 6

On the other hand, 7

2µδ t +2σ δ Bt µδ t +σ δ Bt
E [(δ St ) ] =
2
St2 E [e − 2e + 1] 9

2
(2µ+2σ 2 )δ t (µ+ σ )δ t
= St2 [e − 2e 2 + 1] 10

σ2
   
= St2 (2µ + 2σ 2 )δ t − 2 µ + δ t + O((δ t )2 ) 11
2
= St2 [σ 2 δ t + O((δ t )2 )] 12

= St2 σ δ t + O((δ t ) ),
2 2
(2.9) 13

and from Eq. (2.8) we get have 14

E [(δ St )2 ] = E [St2 (σ 2 (δ Bt )2 + 2µσ δ t δ Bt ) + G2 (δ t )] 15

= St2 σ 2 δ t + E [G2 (δ t )]. (2.10) 16

From Eq. (2.9) and (2.10) we get that 17

E [G2 (δ t )] = O((δ t )2 ). (2.11) 18

Therefore Eqs. (2.8) and (2.11) hold. 19

Let C = C (t , St ) be the value of a European call on the above underlying stock at time t with expiration date T and 20

exercise price X and the boundary conditions: 21

C (T , ST ) = (ST − X ) +
at t = T , (2.12) 22

and C (t , 0) = 0, 23

where C (t , S ) is assumed to have continuous partial derivatives up to order two. 24

Consider a replicating portfolio Πt with X1 (t ) units of the stock and X2 (t ) units of the bond. The value of the portfolio is 25

given by 26

Πt = X1 (t )St + X2 (t )Dt . (2.13) 27

After the time interval δ t, the change in the value of the portfolio is 28

δ Πt = X1 (t )δ St + X2 (t )δ Dt . (2.14) 29

Since C (t , S ) is assumed to have continuous partial derivatives up to order two, the change in the value of the option is 30

∂C ∂C 1 ∂ 2C
δC = δt + δS + (δ S )2 + G3 (δ t ), (2.15) 31
∂t ∂S 2 ∂ S2
where E [G3 (δ t )] = o(δ t ). (2.16) 32

Hence from Eqs. (2.14) and (2.15) we get that 33

∂C ∂C 1 ∂ 2C
   
δ C − δ Πt = − rX2 (t )Dt δ t + − X1 ( t ) δ S + (δ S )2 + G3 (δ t ) 34
∂t ∂S 2 ∂ S2
2

= A1 (t )δ t + Ai+1 (t )(δ S )i + G3 (δ t ), (2.17) 35

i =1
 4 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx

1 where
∂C
2 A1 (t ) = − rX2 (t )Dt , (2.18)
∂t
∂C
3 A2 (t ) = − X1 (t ), (2.19)
∂S
1 ∂ 2C
4 and A3 (t ) = . (2.20)
2 ∂ S2
5 From Eqs. (2.4), (2.8) and (2.17)–(2.20) we have

σ2
  
6 δC − δ = A1 (t )δ t + SA2 (t ) µδ t + σ (1 + µδ t )δ Bt + (δ Bt )2 + A2 (t )G1 (δ t )
t
2

+ S A3 (t ) 2µσ δ t δ Bt + σ (δ Bt )
2 2 2
+ A3 (t )G2 (δ t ) + G3 (δ t ).
 
7

8 Thus

δC − δ = (A1 (t ) + A2 (t )S µ) δ t + σ (1 + µδ t )SA2 (t ) + 2µσ S 2 A3 (t )δ t δ Bt
 
9

σ2
 
10 + SA2 (t ) + σ 2 S 2 A3 (t ) (δ Bt )2 + G4 (δ t ), (2.21)
2
11 where

12 G4 (δ t ) = A2 (t )G1 (δ t ) + A3 (t )G2 (δ t ) + G3 (δ t ),

13 and

14 E [G4 (δ t )] = o ((δ t )) . (2.22)

15 We aim to minimize some functional form of the hedging error, i.e., we consider minimizing

16 Var X1 (t ) (δ C − δ Πt ). (2.23)

17 Furthermore, we will show that the appropriate option price can be given by solving the following optimization problem
18 for the minimum:

19 MinX1 (t ) [Var (δ C −δ Πt ) ] (2.24)

20 subject to

21 E (δ C − δ Πt ) = 0, (2.25)

22 and

23 C (t , St ) = Πt
24 = X1 (t )St + X2 (t )Dt . (2.26)

25 In the following we will give a solution for the mean–variance optimal problem which satisfies Eqs. (2.24)–(2.26).
26 Firstly, from Eq. (2.21) we have
 
σ2
  
27 E δC − δ = (A1 (t ) + A2 (t )S µ) δ t + SA2 (t ) + σ 2 S 2 A3 (t ) δ t + E [G4 (δ t )]. (2.27)
t
2

28 Since E (δ C − δ Πt ) = 0, from Eq. (2.27) we obtain that

σ2
 
29 A1 (t ) + µS + S A2 (t ) + σ 2 S 2 A3 (t ) = 0. (2.28)
2
30 Secondly, from Eqs. (2.21), (2.27) and (2.28) we have
2
Var (δ C − δ Πt ) = σ (1 + µδ t )SA2 (t ) + 2µσ S 2 A3 (t )δ t δ t + E [G5 (δ t )],

31 (2.29)

32 where

33 E [G5 (δ t )] = o ((δ t )) . (2.30)

 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx 5

To minimize the value of the Var (δ C − δ Πt ), we choose X1 (t ) such that it satisfies 1

∂[Var (δ C − δ Πt )]
= 0. (2.31) 2
∂ X1 (t )
Therefore from Eq. (2.29) and the condition (2.31), we obtain that 3

∂C µδ t ∂ 2 C
X1 (t ) = + S, (2.32) 4
∂S 1 + µδ t ∂ S 2

which is a mixed hedging strategy of the delta and the gamma and which is the generalization of the delta hedging strategy 5

of the Black–Scholes–Merton. 6

Finally, substituting Eqs. (2.18)–(2.20), (2.26) and (2.32) into Eq. (2.28), we get that 7

(r − µ − σ2 )µδ t 2 ∂ 2 C
2
 
∂C ∂C σ2
+ rS + + S = rC , (2.33) 8
∂t ∂S 2 1 + µδ t ∂ S2

where 9

 21
2(r − µ − σ2 )µδ t
2

σ̂ = σ 2 + > 0 as δ t is small enough. (2.34) 10
1 + µδ t

From Eq. (2.33), we obtain that 11

12

C (t , St ) = C0 (t , St ) 13

−r (T −t )
= St N (d1 ) − X e N (d2 ), (2.35) 14

where C0 (t , St ) denotes the Black–Scholes price of a European call with volatility σ̂ , 15

N (•) is the distribution function of a standard normal distribution, 16

ln (St /X ) + (r + σ̂2 )(T − t )

2

d1 = √ , (2.36) 17
σ̂ T − t
√
and d2 = d1 − σ̂ T − t. 18

In particular, if δ t = 0, from Eqs. (2.35) and (2.36) we have 19

20

C (t , St ) = C0 (t , St )
= St N (d1 ) − X e−r (T −t ) N (d2 ), (2.37) 21

σ2
ln (St /X ) + (r + )(T − t )
d1 = √ 2
, (2.38) 22
σ T −t
√
and d2 = d1 − σ T − t. 23

3. A numerical comparison of the X1 (t ) hedging and the delta hedging in portfolio management 24

Mantegna and Stanley [1–4], Bouchaud and Potters et al. [7,8], and Wilmott [13,14] discovered that the scaling law and 25

the risk preference parameter µ play an important role in option pricing and pointed out that it must be measured in some 26

cases. In this section, we examine the effect of the trading frequency (i.e., fractal scaling) and the mixed hedging strategy on 27

the portfolio hedging errors of the option pricing models. We consider daily, weekly, two-weekly, and monthly frequencies 28

as the rebalancing frequency and get that the X1 (t ) hedging is better than the delta hedging in some cases. 29

Now, we distinguish and analyze the final hedging costs and the effective costs of the hedging strategy. Recall that the 30

final hedging cost of a call option is given by (i.e., see Refs. [19,21]) 31

hedging cost = cumulative cost − exercise price if X < ST (in-the-money) 32

 6 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx

Table 3.1.1
Simulation of delta hedging per day with an exercise price X = $50, risk-free rate r = 0.05 per annum, expected return rate µ = 0.11 per annum, volatility
σ = 0.2 per annum, and T = 20/252 years.
Day Stock price Delta Shares purchased Cost of shares purchased Cumulative cost Interest cost Option price
including interest

0 49.00 0.39744687 39744.68686 1947489.656 1947489.656 386.407 0.755049526

1 50.30 0.58122725 18378.03829 924415.326 2872291.389 569.899 1.363360522
2 50.76 0.64645526 6522.800969 331097.377 3203958.665 635.706 1.618447184
3 49.99 0.53468627 −11176.89932 −558733.197 2645861.174 524.972 1.13056659
4 49.94 0.52566046 −902.5808265 −45074.886 2601311.260 516.133 1.072936894
5 50.43 0.6029095 7724.904511 389566.934 2991394.328 593.531 1.321281598
6 51.38 0.7453879 14247.83966 732054.002 3724041.860 738.897 1.941057664
7 51.12 0.71469942 −3068.847962 −156879.508 3567901.249 707.917 1.720137104
8 50.74 0.6601974 −5450.20207 −276543.253 3292065.913 653.188 1.42247039
9 50.88 0.68816631 2796.890609 142305.794 3435024.895 681.553 1.485283041
10 50.57 0.63842075 −4974.55581 −251563.287 3184143.160 631.774 1.238817091
11 51.51 0.80326269 16484.1936 849100.812 4033875.747 800.372 1.902144998
12 52.16 0.89420456 9094.187204 474352.805 4509028.924 894.649 2.44027873
13 51.88 0.87812079 −1608.377158 −83442.607 4426480.966 878.270 2.167027161
14 53.03 0.97502963 9690.883953 513907.576 4941266.812 980.410 3.239906242
15 52.48 0.96144067 −1358.895351 −71314.828 4870932.394 966.455 2.695058872
16 51.54 0.89398205 −6745.862182 −347681.737 4524217.112 897.662 1.787166376
17 51.24 0.87713905 −1684.2998 −86303.522 4438811.252 880.717 1.48517723
18 51.31 0.93092541 5378.635875 275977.807 4715669.775 935.649 1.523345813
19 52.16 0.99963618 6871.076505 358395.351 5075000.775 1006.945 2.35800989
20 52.28 1 36.38244552 1902.074 5077909.793 1007.522 2.28
Hedging cost = $77909.793, discounted hedging cost = $77601.240, and hedging error ratio = 0.027763577.

Table 3.1.2
Simulation of X1 (t ) hedging per day with an exercise price X = $50, risk-free rate r = 0.05 per annum, expected return rate µ = 0.11 per annum, volatility
σ = 0.2 per annum, and T = 20/252 years.
Day Stock price X 1 (t ) Shares purchased Cost of shares purchased Cumulative cost Interest cost Option price
including interest

0 49.00 0.400 40032.94 1961614.012 1961614.012 389.209 0.75411995

1 50.30 0.584 18405.54 925798.771 2887801.992 572.977 1.35688769
2 50.76 0.650 6521.20 331015.929 3219390.898 638.768 1.60518500
3 49.99 0.538 −11155.72 −557674.424 2662355.242 528.245 1.11442391
4 49.94 0.529 −892.44 −44568.383 2618315.104 519.507 1.05207126
5 50.43 0.606 7731.65 389907.349 3008741.960 596.973 1.29158632
6 51.38 0.749 14209.92 730105.879 3739444.811 741.953 1.89707145
7 51.12 0.718 −3041.21 −155466.874 3584719.891 711.254 1.67106041
8 50.74 0.664 −5413.82 −274697.232 3310733.913 656.892 1.37080760
9 50.88 0.692 2802.02 142566.577 3453957.381 685.309 1.42470059
10 50.57 0.643 −4937.06 −249667.240 3204975.451 635.908 1.17649750
11 51.51 0.807 16403.08 844922.454 4050533.813 803.677 1.81542653
12 52.16 0.897 8997.50 469309.423 4520646.914 896.954 2.33461536
13 51.88 0.881 −1566.87 −81288.975 4440254.893 881.003 2.05465921
14 53.03 0.976 9498.41 503700.931 4944836.827 981.118 3.10500826
15 52.48 0.963 −1309.07 −68700.145 4877117.800 967.682 2.55259246
16 51.54 0.897 −6551.39 −337658.544 4540426.939 900.878 1.64613655
17 51.24 0.881 −1594.01 −81676.837 4459650.980 884.851 1.33814197
18 51.31 0.934 5293.98 271633.915 4732169.747 938.923 1.35779302
19 52.16 1.000 6533.90 340808.094 5073916.764 1006.730 2.16998088
20 52.28 1.000 31.45 1644.385 5076567.878 1007.256 2.28000000
Hedging cost = $76567.878, discounted hedging cost = $76264.640, and hedging error ratio = 0.011306479.

1 or

2 hedging cost = cumulative cost ifX > ST (out-the-money),

3 while the effective cost of the hedging strategy is

4 effective cost = discounted hedging cost − option price.
5 The hedging cost is the cost of doing hedging independently of the option price evaluated by the traders, while the
6 effective cost represents the real loss of a given strategy considering a particular model to estimate the options.
7 In order to explain our comparison of the X1 (t ) hedging and the delta hedging, we give the following example. Throughout
8 this section, the daily, weekly, two-weekly, and monthly stock price data are obtained by means of simulating sample paths
9 of a geometric Brownian motion with drift coefficient µ1 = 0.13 and diffusion coefficient σ = 0.2 (i.e., see Tables 3.1.1,
10 3.1.2, 3.2.1–3.2.7, 3.3.1, 3.3.2, 3.4.1 and 3.4.2).
 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx 7

Table 3.2.1
Performances of delta hedging and X1 (t ) hedging per week across the different exercise prices with the expected return rate µ1 = 0.13 per annum
(δ t = 52
1
).
Exercise price Delta X 1 (t )
In the money Hedging cost Effective cost Hedging error ratio Hedging cost Effective cost Hedging error ratio

50 360657.01 33443.62 0.1055 354007.03 28228.07 0.0894

55 204670.95 61547.35 0.4483 195213.77 53470.07 0.3926
60 153046.27 97685.57 1.9151 141619.92 87292.95 1.7354
65 136681.64 116218.61 7.0110 126393.51 106573.49 6.5680
Out of the money
70 −22281.29 −26462.16 −5.4964 −24695.06 −28664.90 −6.1354
75 10543.59 8968.80 7.0344 11081.98 9541.54 7.7869
80 1619.65 1260.25 4.0219 1747.93 1400.25 4.6992

Table 3.2.2
Simulation of X1 (t ) hedging per week with an exercise price X = $50, free risk rate r = 0.05 per annum, expected return rate µ = 0.11 per annum, and
volatility σ = 0.2 per annum (δ t = 52
1
).
Week Stock price X 1 (t ) Shares purchased Cost of shares purchased Cumulative cost Interest cost Option price
including interest

0 49 0.558 55833.22 2735827.982 2735827.982 2630.604 3.15713104

1 51.91 0.701 14297.48 742181.953 3480640.539 3346.770 4.90492437
2 50.6 0.638 −6319.97 −319790.569 3164196.740 3042.497 3.95672778
3 52.35 0.722 8345.36 436879.466 3604118.703 3465.499 5.06083552
4 51.68 0.691 −3092.25 −159807.273 3447776.929 3315.170 4.51215070
5 54.07 0.795 10473.84 566320.523 4017412.622 3862.897 6.20170604
6 54.1 0.799 316.24 17108.545 4038384.064 3883.062 6.14702516
7 53.78 0.788 −1054.76 −56725.166 3985541.960 3832.252 5.81502479
8 53.63 0.784 −406.83 −21818.480 3967555.732 3814.957 5.61684905
9 56.04 0.873 8909.21 499272.281 4470642.971 4298.695 7.53048639
10 55.99 0.875 208.52 11675.077 4486616.743 4314.055 7.41121201
11 58.82 0.943 6776.04 398566.786 4889497.584 4701.440 9.91395625
12 59.92 0.962 1871.18 112121.183 5006320.207 4813.769 10.89625134
13 57.97 0.936 −2606.07 −151073.679 4860060.297 4673.135 8.98336884
14 57.25 0.925 −1050.53 −60142.647 4804590.785 4619.799 8.24529856
15 56.54 0.913 −1230.85 −69592.534 4739618.050 4557.325 7.52160726
16 61.37 0.986 7288.18 447275.477 5191450.852 4991.780 12.07399661
17 61.25 0.987 171.34 10494.325 5206936.956 5006.670 11.90074970
18 61.67 0.991 413.87 25523.450 5237467.076 5036.026 12.26219085
19 61.27 0.992 46.19 2830.313 5245333.415 5043.590 11.81272212
20 63.94 0.999 673.24 43046.695 5293423.700 5089.830 14.42089685
21 62.53 0.998 −67.00 −4189.36 5294324.168 5090.696 12.96429275
22 66.43 1.000 197.21 13100.92 5312515.784 5108.188 16.81323993
23 66.21 1.000 4.00 265.01 5317888.981 5113.355 16.54544823
24 66.96 1.000 2.74 183.78 5323186.120 5118.448 17.24763538
25 62.86 1.000 −5.47 −344.05 5327960.514 5123.039 13.09987053
26 64.88 1.000 5.80 376.58 5333460.134 5128.327 15.07193886
27 66.38 1.000 0.06 3.97 5338592.432 5133.262 16.52402294
28 69.12 1.000 0.00 0.00 5343725.699 5138.198 19.21606145
29 69.46 1.000 0.00 0.00 5348863.897 5143.138 19.50805382
30 69.54 1.000 0.00 0.00 5354007.035 5148.084 19.54000000
Hedging cost = $354007.035, discounted hedging cost = $343941.172, and hedging error ratio =0.089410505.

Example 3.1. We use, as an example, the position of a financial institution that has sold for $420,000 a European call 1

option on 100,000 shares of a non-dividend-paying stock. We assume that the stock price is $49, the strike price is $50, 2

the risk-free interest rate is 5% per annum, the stock price volatility is 20% per annum, the time to maturity is 20 days 3

(T = 20/252 years), and the expected return µ1 from the stock is 13% per annum. With our usual notation, this means that 4

S0 = 49, X =, r = 0.05, σ = 0.20, T = 20/252 , and µ1 = 0.13. 5

3.1. A comparison of the daily delta hedging and X1 (t ) hedging 6

3.1.1. In the case of the delta hedging 7

Under the conditions of Example 3.1, from Eqs. (2.37) and (2.38) we obtained the following results. 8

The Black–Scholes price of the option is about $75,504.953. The hedge is assumed to be adjusted or rebalanced daily. By 9

Day20, the total cost of writing the option and hedging is $77909.793 (see Table 3.1.1). 10

If this total cost is discounted to the beginning of the period, it is equal to $77601.240, which is close to the Black–Scholes 11

price 75,504.953. 12
 8 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx

Table 3.2.3
Simulation of X1 (t ) hedging per week with an exercise price X = $50, risk-free rate r = 0.05 per annum, expected return rate µ = 0.11 per annum,
volatility σ = 0.2 per annum, and T = 20/52 years.
Week Stock price X 1 (t ) Shares purchased Cost of shares purchased Cumulative cost Interest cost Option price
including interest

0 49.00 0.528 52829.53 2588647.163 2588647.163 2489.084 2.390284097

1 48.07 0.461 −6714.15 −322749.421 2268386.826 2181.141 1.855047743
2 48.21 0.465 424.56 20468.164 2291036.132 2202.919 1.838284156
3 46.85 0.362 −10316.58 −483331.727 1809907.324 1740.296 1.206934645
4 47.33 0.389 2627.16 124343.349 1935990.968 1861.530 1.307834184
5 47.92 0.425 3645.41 174688.023 2112540.521 2031.289 1.461829453
6 48.80 0.487 6198.60 302491.856 2417063.666 2324.100 1.767206003
7 47.73 0.394 −9342.21 −445903.869 1973483.897 1897.581 1.214570555
8 46.93 0.318 −7504.08 −352166.304 1623215.173 1560.784 0.852952735
9 46.17 0.246 −7209.46 −332860.622 1291915.335 1242.226 0.569359786
10 45.67 0.195 −5135.30 −234529.207 1058628.354 1017.912 0.3965951
11 46.33 0.227 3189.50 147769.542 1207415.808 1160.977 0.464018352
12 44.05 0.072 −15449.80 −680563.772 528013.012 507.705 0.101371704
13 44.42 0.072 −63.29 −2811.509 525709.208 505.490 0.094429285
14 42.84 0.016 −5543.00 −237462.333 288752.365 277.647 0.015279716
15 42.48 0.006 −1012.01 −42990.191 246039.820 236.577 0.004694372
16 44.49 0.024 1761.63 78374.755 324651.152 312.165 0.019589417
17 44.46 0.010 −1392.88 −61927.470 263035.846 252.919 0.006224825
18 45.18 0.007 −329.17 −14872.118 248416.647 238.862 0.00321821
19 43.89 0.000 −664.24 −29153.453 219502.056 211.060 3.58139E−07
20 42.88 0.000 −0.21 −8.831 219704.285 211.254 0.00
Hedging cost = $219,704.285, discounted hedging cost = $215,519.569, and hedging error ratio = −0.09835166.

1 The error ratio of the Black–Scholes delta hedging is (77601.240 − 75, 504.953)/75, 504.953, which is close to
2 0.027763577.
3 In particular, in the Black–Scholes case we did not consider the impact of the fractal scaling δ t (i.e.,1/52 × 5) on the delta
4 hedging.

5 3.1.2. In the case of the X1 (t ) hedging

6 Under the conditions of Example 3.1, we assume that the formulas (2.32) and (2.35) hold, as δ t = 1/(52 × 5) years
7 (i.e., approximately one day). From Itô’s formula [22], and µ1 = 0.13, we know that µ = 0.11.
8 Table 3.1.2 is the simulation of the X1 (t ) hedging by means of the Microsoft excel 2010, and the daily data of stock prices
9 are the same as the delta hedging.
10 From Table 3.1.2, we know the X1 (t ) hedging price of the option is about $75,411.995. By Day20, the total cost of
11 writing the option and hedging is $76567.878. If this total cost is discounted to the beginning of the period, it is equal
12 to $76264.640, which is close to the X1 (t ) hedging option price $75,411.995. The error ratio of the X1 (t ) hedging is
13 (76264.640 − 75, 411.995)/75, 411.995, which is close to 0.011306479, and which is smaller than the error ratio of the
14 delta hedging.

15 3.2. A comparison of the weekly delta hedging and X1 (t ) hedging

16 3.2.1. In the case of the delta hedging

17 In Example 3.1, if the time to maturity is assumed to be 30 weeks (0.5769 years), from Eqs. (2.36) and (2.37) we obtained
18 the following results.
19 The error ratio of the Black–Scholes delta hedging is close to 10.6%.
20 Table 3.2.1 reports that the error ratio of the X1 (t ) hedging is smaller than the delta one at the end of the period, except
21 for X = 70, 75, and 80.

22 3.2.2. In the case of the X1 (t ) hedging

23 Under the conditions of Example 3.1, the time to maturity is assumed to be 30 weeks (0.5769 years), and the formulas
24 (2.32) and (2.35) are assumed to be held, as δ t = 1/52 years (i.e., approximately one week).
25 Table 3.2.2 is the simulation of the X1 (t ) hedging when the stock price is an upward trend, and the weekly data of stock
26 prices are the same as the delta hedging.
27 From Table 3.2.2, we know the X1 (t ) hedging price of the option is about $315713.104. By Week 30, the total cost of
28 writing the option and hedging is equal to $354007.035. If this total cost is discounted to the beginning of the period, it is
29 equal to $343941.172, which is close to the X1 (t ) hedging option price $315713.104. The error ratio of the X1 (t ) hedging is
30 (343941.172 − 315713.104)/315713.104, which is close to 8.941%, and which is smaller than the error ratio of the delta
31 hedging.
 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx 9

Table 3.2.4
Simulation of the delta hedging per week with an exercise price X = $50, risk-free rate r = 0.05 per annum, expected return rate µ = 0.11 per annum,
volatility σ = 0.2 per annum, and T = 20/52 years.
Week Stock Delta Shares Cost of shares purchased Cumulative cost Interest Option price
price purchased including interest cost

0 49.00 0.521604661 52160.46611 2555862.839 2555862.839 2457.560 2.400527323

1 48.07 0.454599644 −6700.501756 −322093.119 2236227.280 2150.219 1.884002098
2 48.21 0.458624732 402.5088005 19404.949 2257782.448 2170.945 1.886735909
3 46.85 0.356094442 −10253.0289 −480354.404 1779598.989 1711.153 1.25993309
4 47.33 0.381888555 2579.411265 122083.535 1903393.677 1830.186 1.380635057
5 47.92 0.417778188 3588.963285 171983.121 2077206.984 1997.314 1.559297871
6 48.80 0.479071458 6129.327007 299111.158 2378315.456 2286.842 1.900015228
7 47.73 0.386050137 −9302.132083 −443990.764 1936611.533 1862.126 1.337700379
8 46.93 0.311572354 −7447.778323 −349524.237 1588949.423 1527.836 0.965151814
9 46.17 0.240288402 −7128.395162 −329118.005 1261359.254 1212.845 0.66558117
10 45.67 0.189618922 −5066.948039 −231407.517 1031164.583 991.504 0.480210009
11 46.33 0.220471583 3085.266073 142940.377 1175096.465 1129.900 0.57138186
12 44.05 0.069730228 −15074.13544 −664015.666 512210.699 492.510 0.137372062
13 44.42 0.068878648 −85.15800052 −3782.718 508920.491 489.347 0.133060264
14 42.84 0.015540408 −5333.824073 −228501.023 280908.814 270.105 0.024446865
15 42.48 0.00587444 −966.596776 −41061.031 240117.888 230.883 0.008381363
16 44.49 0.022331086 1645.664654 73215.620 313564.391 301.504 0.034999841
17 44.46 0.009125219 −1320.586744 −58713.287 255152.608 245.339 0.012917829
18 45.18 0.005938818 −318.640055 −14396.158 241001.790 231.732 0.007889437
19 43.89 1.65314E−06 −593.7165265 −26058.218 215175.304 206.899 1.70389E−06
20 42.88 0 −0.165314407 −7.089 215375.115 207.091 0.00
Hedging cost = $215,375.115, discounted hedging cost = $11,272.857, and hedging error ratio = −0.119889806.

Table 3.2.5
Simulation of X1 (t ) hedging per week with an exercise price X = $50, risk-free rate r = 0.05, expected return rate µ = 0.11, volatility σ = 0.2 per
annum, and T = 20/52 years.
Week Stock price X 1 (t ) Shares purchased Cost of shares purchased Cumulative cost Interest cost Option price
including interest

0 49.00 0.541 54067.80 2649321.975 2649321.975 3056.910 2.481646542

1 51.35 0.685 14409.40 739927.907 3392306.792 3914.200 3.817652849
2 50.28 0.618 −6653.54 −334515.822 3061705.170 3532.737 3.029632893
3 49.82 0.586 −3266.54 −162741.294 2902496.612 3349.035 2.663340605
4 47.67 0.424 −16135.91 −769136.052 2136709.595 2465.434 1.496999074
5 48.69 0.495 7085.82 345037.123 2484212.152 2866.399 1.871147814
6 49.41 0.545 5011.75 247629.039 2734707.589 3155.432 2.139952589
7 51.63 0.707 16133.57 832941.676 3570804.697 4120.159 3.409269791
8 51.80 0.720 1371.09 71018.172 3645943.028 4206.857 3.42068926
9 49.59 0.546 −17388.45 −862207.245 2787942.640 3216.857 1.918205098
10 49.68 0.550 384.78 19115.369 2810274.866 3242.625 1.855962234
11 52.10 0.754 20416.35 1063654.422 3877171.913 4473.660 3.300228368
12 50.82 0.653 −10161.33 −516410.360 3365235.213 3882.964 2.28710979
13 50.96 0.669 1576.85 80353.923 3449472.099 3980.160 2.245747028
14 49.41 0.497 −17161.38 −847961.742 2605490.517 3006.335 1.218795716
15 49.76 0.533 3581.61 178237.504 2786734.357 3215.463 1.25216875
16 51.16 0.714 18141.94 928181.414 3718131.234 4290.151 1.944522561
17 49.32 0.441 −27280.97 −1345388.948 2377032.437 2742.730 0.712694125
18 49.57 0.465 2403.07 119127.759 2498902.926 2883.350 0.629384775
19 49.19 0.323 −14188.87 −697999.265 1803787.011 2081.293 0.251652037
20 48.21 0.000 −32347.05 −1559427.209 246441.095 284.355 0
Hedging cost = $246441.095, discounted hedging cost = $240819.111, and hedging error ratio = −0.029599473.

Under the conditions of Example 3.1, if the time to maturity is assumed to be 20 weeks, and the formulas (2.32) and 1

(2.35) are assumed to be held, as δ t = 1/52 years (i.e., approximately one week), Tables 3.2.3 and 3.2.4 are the simulations 2

of the X1 (t ) hedging and the delta hedging when the stock price is a downward trend. 3

Under the conditions of Example 3.1, if the time to maturity is assumed to be 20 weeks, and the formulas (2.32) and 4

(2.35) are assumed to be held, as δ t = 1/52 years (i.e., approximately one week), Tables 3.2.5 and 3.2.6 are the simulations 5

of the X1 (t ) hedging and the delta hedging when the stock prices are fluctuations. 6

From Tables 3.2.1–3.2.6, we know that the X1 (t ) hedging is better than the delta hedging whether the stock price per 7

week is an upward or a downward trend or a fluctuation in some cases. 8

Under the conditions of Tables 3.2.1 and 3.2.2, Table 3.2.7 is the simulations of the X1 (t ) hedging and the delta hedging 9

when expected return rate µ is assumed to varied, if the formulas (2.32) and (2.35) are assumed to be held, as δ t = 1/52 10

years (i.e., approximately one week) with σ = 0.20, T = 0.5769, S0 = 49, X = 50, and r = 0.05. 11
 10 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx

Table 3.2.6
Simulation of delta hedging per week with an exercise price X = $50, risk-free rate r = 0.05, expected return rate µ = 0.11 per annum, volatility σ = 0.2
per annum, and T = 20/52 years.
Week Stock price Delta Shares purchased Cost of shares purchased Cumulative cost Interest cost Option price
including interest

0 49.00 0.52160466 52160.46611 2555862.839 2555862.839 2457.560 2.400527323

1 51.35 0.66712733 14552.26728 747263.967 3305584.366 3178.447 3.742819405
2 50.28 0.5997772 −6735.013171 −338612.173 2970150.639 2855.914 2.995289087
3 49.82 0.56698625 −3279.095478 −163366.858 2809639.696 2701.577 2.660837628
4 47.67 0.40643015 −16055.6098 −765308.610 2047032.662 1968.301 1.51758746
5 48.69 0.47670888 7027.873549 342215.295 2391216.258 2299.246 1.919104862
6 49.41 0.52677679 5006.790322 247384.167 2640899.672 2539.327 2.220171984
7 51.63 0.68983663 16305.98411 841843.307 3485282.306 3351.233 3.551298644
8 51.80 0.70388389 1404.725979 72760.308 3561393.846 3424.417 3.603864263
9 49.59 0.52805521 −17582.86781 −871847.504 2692970.759 2589.395 2.08253139
10 49.68 0.53187794 382.2730173 18990.844 2714550.998 2610.145 2.050152654
11 52.10 0.73879925 20692.13078 1078021.849 3795182.992 3649.214 3.614946813
12 50.82 0.63492599 −10387.32614 −527895.647 3270936.560 3145.131 2.590588704
13 50.96 0.65069303 1576.70438 80346.530 3354428.221 3225.412 2.593423623
14 49.41 0.47785949 −17283.35399 −853988.423 2503665.209 2407.370 1.497411011
15 49.76 0.51294525 3508.576054 174603.076 2680675.656 2577.573 1.581094432
16 51.16 0.69543172 18248.64651 933640.515 3616893.743 3477.782 2.436042033
17 49.32 0.41970057 −27573.11454 −1359796.426 2260575.099 2173.630 1.028689677
18 49.57 0.44041363 2071.305475 102681.237 2365429.966 2274.452 0.987949877
19 49.19 0.29534962 −14506.40111 −713619.803 1654084.615 1590.466 0.509134797
20 48.21 0 −29534.96152 −1423858.623 231816.458 222.900 0.00
Hedging cost = $231816.458, discounted hedging cost = $227401.041, and hedging error ratio =−0.052703801.

Table 3.2.7
Performances of the delta hedging and X1 (t ) hedging per week with the varied expected return rate µ(δ t = 1
52
).
µ Delta X1 (t )
Hedging cost Effective cost Hedging error ratio Hedging cost Effective cost Hedging error ratio

0.07 356667.02 29963.06 0.0947

0.08 356028.27 29512.23 0.0933
0.09 355372.09 29072.83 0.0919
0.1 354698.39 28644.79 0.0907
0.11 360657.01 33443.62 0.1055 354007.03 28228.07 0.0894
0.12 353297.92 27822.59 0.0882
0.13 352570.90 27428.30 0.0870
0.14 351825.85 27045.13 0.0859
0.15 351062.60 26673.03 0.0848

Table 3.3.1
Performances of the delta hedging and X1 (t ) hedging per two week across different exercise prices (δ t = 2
52
).
Exercise price Delta x1 (t )
In the money Hedging cost Effective cost Hedging error ratio Hedging cost Effective cost Hedging error ratio

50 336680.27 10148.64 0.0320 323422.15 −236.51 −0.0008

55 171086.72 28918.06 0.2106 153023.13 13593.28 0.1006
60 84419.85 31010.49 0.6079 63365.95 11971.94 0.2414
65 45503.13 27632.68 1.6670 24890.42 8304.32 0.5230
Out of the money
70 −98078.82 −100104.45 −20.7926 −105227.60 −106767.40 −23.5593
75 −15490.54 −16325.08 −12.8041 −16179.73 −16896.57 −14.3569
80 −2786.28 −3020.41 −9.6391 −2857.30 −3059.20 −10.8045

1 In Table 3.2.7, it has been shown that risk preference parameter µ has an important influence on the effective cost
2 and the hedging error ratio in the case of the X1 (t ) hedging, even if it does not play any role in the case of the delta
3 hedging.

4 3.3. A comparison of the two-weekly delta hedging and X1 (t ) hedging

5 In Tables 3.2.1 and 3.2.2, if δ t is assumed to be 2/52 years (i.e., approximately two weeks), and the formulas (2.32) and
6 (2.35) are assumed to be held with S0 = 49, X = 50, r = 0.05, σ = 0.20, µ1 = 0.13, and T = 0.5769, Tables 3.3.1 and
7 3.3.2 are the simulations of the X1 (t ) hedging and the delta hedging.
 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx 11

Table 3.3.2
Performances of delta hedging and X1 (t ) hedging per two week with the varied expected return rate µ, but with the fixed exercise price X = $50 (δ t = 2
52
).
µ Delta X 1 (t )
Hedging cost Effective cost Hedging error ratio Hedging cost Effective cost Hedging error ratio

0.07 328801.10 3285.99 0.0104

0.08 327517.71 2379.17 0.0075
0.09 326193.76 1490.00 0.0047
0.1 324828.75 618.20 0.0020
0.11 336680.27 10148.64 0.0320 323422.15 −236.51 −0.0008
0.12 321973.35 −1074.44 −0.0034
0.13 320481.71 −1895.92 −0.0061
0.14 318946.52 −2701.28 −0.0086
0.15 317367.03 −3490.89 −0.0112

Table 3.4.1
Simulation of X1 (t ) hedging per month with an exercise price X = $50, risk-free rate r = 0.05 per annum, expected return rate µ = 0.11 per annum,
volatility σ = 0.2 per annum, and T = 20/12 years.
Month Stock price X 1 (t ) Shares purchased Cost of shares purchased Cumulative cost Interest cost Option price
including interest

0 49.00 0.660 65979.04 3232973.143 3232973.143 13470.721 6.436247167

1 52.54 0.752 9251.77 486087.830 3732531.695 15552.215 8.665874197
2 53.98 0.785 3263.14 176144.193 3924228.103 16350.950 9.516204482
3 53.29 0.768 −1700.12 −90599.655 3849979.398 16041.581 8.743904732
4 53.88 0.782 1370.76 73856.522 3939877.501 16416.156 8.944880413
5 53.61 0.775 −704.49 −37767.899 3918525.758 16327.191 8.484291527
6 49.80 0.657 −11719.68 −583640.004 3351212.945 13963.387 5.543763121
7 48.25 0.594 −6351.69 −306468.865 3058707.467 12744.614 4.349715487
8 45.55 0.470 −12408.99 −565229.383 2506222.698 10442.595 2.722448274
9 43.64 0.368 −10213.53 −445718.362 2070946.931 8628.946 1.747278825
10 42.28 0.286 −8118.72 −343259.663 1736316.214 7234.651 1.144179828
11 42.16 0.259 −2702.05 −113918.325 1629632.539 6790.136 0.947681137
12 38.68 0.104 −15535.83 −600925.884 1035496.791 4314.570 0.257371298
13 42.08 0.206 10158.27 427459.844 1467271.205 6113.630 0.613154626
14 46.56 0.421 21543.71 1003074.936 2476459.771 10318.582 1.679873267
15 46.93 0.420 −84.46 −3963.848 2482814.506 10345.060 1.538065301
16 47.29 0.417 −288.42 −13639.330 2479520.237 10331.334 1.366133278
17 46.58 0.325 −9281.06 −432311.855 2057539.716 8573.082 0.800822629
18 50.62 0.660 33574.48 1699540.031 3765652.830 15690.220 2.171999547
19 50.12 0.621 −3973.55 −199154.451 3582188.599 14925.786 1.300900238
20 47.14 0.000 −62058.56 −2925440.550 671673.834 2798.641 0.00
Hedging cost = $671673.834, discounted hedging cost = $617969.760, and hedging error ratio = −0.039860118.

Table 3.3.1 reports that hedging error ratio of the X1 (t ) hedging is smaller than the delta one at the end of the period 1

except for X = 70, 75, and 80. From Table 3.3.1, we know that the X1 (t ) hedging strategy is better than the delta one 2

considering the two-weekly hedging strategy in some cases. 3

Moreover, in Table 3.3.2, it is shown that risk preference parameter µ has an important influence on the effective cost 4

and the hedging error ratio in the case of the X1 (t ) hedging, even if it does not play any role in the case of the delta 5

hedging. 6

3.4. A comparison of the monthly delta hedging and X1 (t ) hedging 7

Under the conditions of Example 3.1, if the time to maturity is assumed to be 20 months, and the formulas (2.32) and 8

(2.35) are assumed to be held, as δ t = 4/52 years (i.e., approximately one month), Tables 3.4.1 and 3.4.2 are the simulations 9

of the X1 (t ) hedging and the delta hedging. 10

From Tables 3.4.1 and 3.4.2, we know that the X1 (t ) hedging strategy is an improvement over the Black–Scholes delta 11

hedging in some sense. 12

Example 3.2. Performance of X1 (t ) hedging for a call option underlying the stock of PingAn Insurance Company of China, Ltd 13

(Stock code:601318). The data set of stock prices comes from the soft of Tong Da Xin. To illustrate the typical performance 14

of X1 (t ) hedging, we consider weekly observations during the period from 2013/02/22 to 2013/07/21. A 20-week maturity 15

European call is given with the exercise price X = $40. 16

From Tables 3.4.3 and 3.4.4, we also know that the X1 (t ) hedging strategy is an improvement over the Black–Scholes 17

delta hedging in some sense and that risk preference parameter µ has an important influence on the hedging error ratio in 18

the case of the X1 (t ) hedging, even if it does not play any role in the case of the delta hedging. 19
12 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx

Table 3.4.2
Simulation of delta hedging per month with an exercise price X = $50, risk-free rate r = 0.05 per annum, expected return rate µ = 0.11 per annum,
volatility σ = 0.2 per annum, and T = 20/12 years.
Month Stock price Delta Shares purchased Cost of shares purchased Cumulative cost Interest cost Option price
including interest

0 49 0.64565026 64565.02638 3163686.293 3163686.293 13182.026 6.522515817

1 52.54 0.73803717 9238.690323 485400.790 3662269.108 15259.455 8.869505563
2 53.98 0.7707565 3271.933616 176618.977 3854147.540 16058.948 9.855121507
3 53.29 0.75310232 −1765.418355 −94079.144 3776127.344 15733.864 9.206126369
4 53.88 0.76662068 1351.835996 72836.923 3864698.131 16102.909 9.548209035
5 53.61 0.75899586 −762.4818547 −40876.652 3839924.388 15999.685 9.215157879
6 49.8 0.6403856 −11861.02618 −590679.104 3265244.969 13605.187 6.266193984
7 48.25 0.57657695 −6380.864766 −307876.725 2970973.431 12379.056 5.094413116
8 45.55 0.45380174 −12277.52129 −559241.095 2424111.392 10100.464 3.374857327
9 43.64 0.35368432 −10011.74218 −436912.429 1997299.427 8322.081 2.305814822
10 42.28 0.27456165 −7912.266295 −334530.619 1671090.889 6962.879 1.616297761
11 42.16 0.24775597 −2680.568717 −113012.777 1565040.991 6521.004 1.413393983
12 38.68 0.09918868 −14856.72882 −574658.271 996903.724 4153.766 0.450821076
13 42.08 0.19444387 9525.519342 400833.854 1401891.344 5841.214 1.042715508
14 46.56 0.39876431 20432.04368 951315.954 2359048.511 9829.369 2.680665855
15 46.93 0.39554096 −322.3345041 −15127.158 2353750.722 9807.295 2.609694727
16 47.29 0.3895421 −599.8868284 −28368.648 2335189.369 9729.956 2.501968748
17 46.58 0.29683773 −9270.4364 −431816.928 1913102.397 7971.260 1.71901328
18 50.62 0.61555281 31871.50755 1613335.712 3534409.369 14726.706 4.29336644
19 50.12 0.55667946 −5887.334484 −295073.204 3254062.870 13558.595 3.344880009
20 47.14 0 −55667.9462 −2624186.984 643434.481 2680.977 0.00
Hedging cost = $643434.481, discounted hedging cost = $591988.301, and hedging error ratio =−0.092392694.

Table 3.4.3
Simulation of X1 (t ) hedging per week with an exercise price X = $40, risk-free rate r = 0.05 per annum, expected return rate µ = 0.27 per annum,
volatility σ = 0.30 per annum, and T = 20/52 years.
Week Date Stock Shares Cost of shares Cumulative cost Interest Option price
price purchased purchased including interest cost

0 2013/02/22 45.96 0.837 83727.00 3848092.975 3848092.975 3700.089 7.555347011

1 2013/03/01 45.95 0.841 348.32 16005.156 3867798.220 3719.037 7.463921489
2 2013/03/08 43.92 0.775 −6604.10 −290052.158 3581465.098 3443.716 5.749510879
3 2013/03/15 41.92 0.688 −8691.65 −364353.829 3220554.986 3096.687 4.208046945
4 2013/03/22 43.11 0.747 5905.64 254591.956 3478243.629 3344.465 4.951214421
5 2013/03/29 41.77 0.683 −6390.82 −266944.422 3214643.672 3091.004 3.906003134
6 2013/04/03 40.76 0.626 −5699.96 −232330.301 2985404.375 2870.581 3.151891137
7 2013/04/12 41.15 0.650 2415.23 99386.805 3087661.761 2968.906 3.28751424
8 2013/04/19 42.90 0.752 10239.01 439253.451 3529884.117 3394.119 4.384784501
9 2013/04/26 39.81 0.559 −19332.45 −769624.677 2763653.560 2657.359 2.267275138
10 2013/05/03 41.09 0.651 9134.92 375353.965 3141664.884 3020.832 2.902457982
11 2013/05/10 41.10 0.654 305.63 12561.202 3157246.917 3035.814 2.783873043
12 2013/05/17 40.45 0.605 −4880.56 −197418.684 2962864.047 2848.908 2.253985909
13 2013/05/24 39.59 0.527 −7728.28 −305962.727 2659750.228 2557.452 1.64412982
14 2013/05/31 39.61 0.525 −294.49 −11664.624 2650643.057 2548.695 1.509496372
15 2013/06/07 37.80 0.321 −20309.69 −767706.194 1885485.558 1812.967 0.633731778
16 2013/06/14 36.86 0.198 −12338.10 −454782.497 1432516.028 1377.419 0.286845631
17 2013/06/21 37.11 0.181 −1675.77 −62187.986 1371705.461 1318.948 0.220377484
18 2013/06/28 34.76 0.011 −17001.08 −590957.379 782067.030 751.988 0.006039256
19 2013/07/05 34.51 0.000 −1101.34 −38007.271 744811.746 716.165 6.44252E−05
20 2013/07/12 35.01 0.000 −27.46 −961.359 744566.552 715.929 0
Hedging cost = $744566.552, discounted hedging cost = $730284.7649, and hedging error ratio = −0.033287599.

Table 3.4.4
Performances of delta hedging and X1 (t ) hedging per week with the varied expected return rates µ, or with the varied exercise price X, as risk-free rate
r = 0.05 per annum, volatility σ = 0.30 per annum, and T = 20/52 years are fixed.
µ(X = 40) Hedging error ratio X (µ = 0.27) Hedging error ratio
X1 (t ) Delta X 1 (t ) Delta

−0.06 −0.0605 32.5 −0.0159 −0.0189

0.006775 −0.0595 35 −0.0762 −0.0866
0.06 −0.0550 −0.0600 37.5 −0.0245 −0.0458
0.13 −0.0486 40 −0.0333 −0.0600
0.2 −0.0413 42.5 −0.0442 −0.0744
0.27 −0.0333 45 −0.0413 −0.0759
 X.-T. Wang et al. / Physica A xx (xxxx) xxx–xxx 13

Remark 1. In the daily and weekly rehedging cases, there is only an error ratio correction of one or three percent, but the 1

X1 (t ) hedging is still important for the hedgers if the shares purchased are large (i.e., see, Tables 3.1.1, 3.1.2, 3.2.1–3.2.7, 2

3.4.3 and 3.4.4). When the large δ t can be experienced, this error ratio correction can reach five or six percent, a value that 3

cannot be ignored (i.e., see, Tables 3.3.1, 3.3.2, 3.4.1 and 3.4.2). Furthermore, when some typical value µ can be experienced, 4

the error ratio correction can also reach five or six percent (i.e., see, Table 3.3.2). On the other hand, Wilmott has concluded 5

that in trending markets when large µ can be experienced the daily correction such as the X1 (t ) hedging can reach five or 6

ten percent; and more importantly, in trending markets, the corrected delta will give a better risk reduction since it is in 7

effect an anticipatory hedge: the variance is minimized over the time horizon until the next rehedge. This has been called 8

hedging with a view (i.e., see, [13,14]). 9

Remark 2. In real markets, the rebalancing frequency should be dynamic and determined by the fluctuation of stock price, so 10

the weekly and two-weekly rebalancing frequency might cause the doubtful results. However, from the point of view of the 11

fractal market hypothesis [23–25], financial markets are considered as complex systems consisting of many heterogeneous 12

traders who are distinguishable mainly with respect to their investment horizons. The behavior of a day trader is quite 13

different from that of a pension fund. In the former case, the investment horizon is measured in minutes; in the later case, 14

in months or in years. The impact of information is largely dependent on each individual’s investment horizon. Different 15

investor horizons lead to different trade decisions. There would be no liquidity, if information had the same impact on all 16

investors. 17

4. Conclusion 18

In this paper, we have proposed a mixed hedging strategy to price options. It has been shown that risk preference 19

parameter µ and fractal scaling δ t as well as residual risk have important influences on the effective cost and the hedging 20

error ratio in option pricing. In particular, we get that the mixed hedging strategy is better than the delta hedging in some 21

cases. 22

References 23

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