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Hedging Volatility Risk: Are Volatility Options More Effective Hedging

Instruments?

Article · April 2006

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Hedging Volatility Risk: Are Volatility Options More Effective Hedging

Instruments?

Yunbi An1
Odette School of Business
University of Windsor
Windsor, Ontario, Canada, N9B 3P4
Email: yunbi@uwindsor.ca
Tel: (519)253-3000 ext. 3133
Fax: (519)973-7073

Ata Assaf
Odette School of Business
University of Windsor
Windsor, Ontario, Canada, N9B 3P4
Email: assaf@uwindsor.ca
Tel: (519)253-3000 ext. 3088
Fax: (519)973-7073

March, 2006

1
Yunbi An will attend the conference meetings and present the paper if accepted.
 Abstract

In this paper we focus on the performance of volatility options as hedging instruments for
hedging volatility risk. We investigate (a) the relative hedging performance of volatility
and European options, (b) the relative hedging performance of volatility index and
straddle options, and (c) the impact of model misspecification on hedging effectiveness.
We focus on exotic options as the options to be hedged, because they are more sensitive
to volatility risk and model risk and practically more relevant when the effectiveness of
different hedging strategies is examined. Using a Monte Carlo simulation, we find that
volatility options are especially useful for hedging options with a severe exotic feature
and there is no significant difference between the performances of volatility index and
straddle options. Further, our results indicate that model misspecification has an
important impact on the hedging performance.

2
1 Introduction

It is well known that the volatility of asset returns tends to change over time. Data has

also shown that the implied asset return distribution is negatively skewed with higher

kurtosis than allowable in the lognormal distribution assumed by Black-Scholes. Due to

the many financial market crises during the last two decades such as LTCM (the Long

Term Capital Management), the Russian default and the Asian financial crisis, academics

and practitioners are seeing volatility risk as one of the prime risk factors in the capital

market. Theoretically, volatility risk can be hedged by standard futures or European

options, but, in practice, the hedging may not be effective due to the lack of available

hedging instruments or the features of standard derivatives.2 Thus, for the purpose of

hedging, a better choice of the hedging instrument is the one whose price is particularly

sensitive to the level of instantaneous volatility. Brenner and Galai (1989) first suggested

developing a volatility index to assist investors in tracking the movements of volatility.

Then in 1993, the Chicago Board of Options Exchange (CBOE) introduced a market

volatility index based on implied volatilities from the S&P 100 index options. Volatility

derivative products such as volatility swaps, volatility futures, volatility index options,

and straddle options have also been introduced to hedge volatility exposure. It is argued

that the payoff of these derivatives depends explicitly on some measure of volatility and

therefore they are more effective hedging instruments than plain-vanilla options.

Given the motivation behind introducing volatility derivatives, it is important to

investigate whether they are indeed better than standard options in terms of hedging

volatility risk. This issue has not received much attention in the current literature.

2
Standard derivatives such as European options and futures are designed mainly to deal with price risk
rather than volatility risk.

3
Psychoyios and Skiadopoulos (2004) examine the hedging effectiveness of volatility

index options compared with that of standard options when the hedged options are

European options. They study the hedging and pricing performance of several volatility

option pricing models, and conclude that volatility options are not better hedging

instruments than plain-vanilla options for hedging standard options. Jiang and Oomen

(2001) investigate the hedging performance of volatility futures versus standard options

and reach the same conclusion.

This paper extends these studies by looking at the effectiveness of the delta-vega

hedge with the use of straddle options. Straddle options, which were first proposed by

Brenner et al. (2001), are options written on an at-the-money-forward straddle rather than

a volatility index. Brenner et al. (2001) argue that since the value of straddles is mainly

affected by volatility, straddle options are actually options on volatility. Moreover, as the

underlying is a traded straddle, such instruments will be more attractive to practitioners

than a volatility index option. To the best of our knowledge, the effectiveness of straddle

options as hedging instruments has not yet been studied.

More importantly, we will focus on exotic options, such as barrier options and

lookback options to be the hedged options, since previous papers concerned with the

hedging of volatility options were limited by their focus on European options as the

hedged instruments. Reasons why exotic options should be considered are as follows.

First of all, exotic options are more sensitive to volatility changes than European options.

Exotic options, such as barrier options, lookback options are path-dependent whose

payoff depends not only on the underlying asset price at maturity but also on all the price

during the option’s life. The prices of such options are dramatically affected by the

4
changes in the underlying asset returns as well as volatilities. To illustrate, let us consider

an up-and-out barrier option as an example. This is an option that will be canceled when

the underlying asset price first reaches a pre-specified upper barrier level. When the

underlying asset price is below the barrier level, the option is in-the-money and valuable.

However, an increase in the underlying price might cause the option to be worthless

while the corresponding European option is still in-the-money. As a result, exotic options

are extremely sensitive to price and volatility risk. Secondly, European options are

actively traded in exchanges and their prices are readily available from brokers and other

sources. Market participants tend to calibrate their models in a way that the models can fit

the market prices as closely as possible and re-calibrate them whenever they mark the

option to markets or rebalance their hedging portfolios. For this reason, model

specification is relatively less important for valuing European options. However, exotic

options are traded in the over-the-counter market, and their market prices might not be

readily available. Consequently, they are more sensitive to model misspecification than

European options. Finally, in practice, market participants tend to calibrate their models

to fit the observed European option prices and then mainly use the resulting models to

compute the prices and hedging parameters for exotic or illiquid options. As a result, it is

more appropriate to consider the exotic options as the target options from the

practitioner’s point of view.

In this paper, to overcome the lack of data on both exotic and volatility options,

we conduct the analysis using a simulation method. Such an approach enables us to

investigate the impact of model error by comparing the effectiveness of hedging

strategies based on a misspecified model with those based on the true model. Following

5
Hull and Suo (2002) and Psychoyios and Skiadopoulos (2004), we adopt the stochastic

volatility setup as the true data generating process. For a particular exotic option, a delta-

vega hedging portfolio is constructed based on an option pricing model to hedge both the

price and the volatility risk. The replicating portfolio includes the underlying asset as well

as either a volatility option or a European option. The prices of the options in the

portfolio are calculated from the true model while the hedging ratios are determined by

the model under consideration. This portfolio will be rebalanced discretely until the

maturity of the exotic option. Hedging errors are used as an indicator of the effectiveness

of the hedging strategy.

We assess the relative hedging performance of two different hedging strategies

against volatility risk as well as the impact of model misspecification on hedging

effectiveness. One hedging strategy employs a standard European option as the hedging

instrument while the other one uses a volatility option. In the second hedging strategy, we

consider two different types of volatility options: volatility index options and straddle

options. To implement the two hedging strategies, we consider the Black-Scholes model

and the mean-reverting Ornstein-Uhlenbeck (OU) stochastic volatility model in the case

of exotic, plain-vanilla European and straddle options. For the case of volatility index

options, Whaley (1993) and Grübichler and Longstaff (1996) models are adpoted.

Our results indicate that volatility options are better hedging instruments than

European options for hedging long-term exotic options. This is true for different types of

hedged options and hedging rebalancing frequencies. Further, we find that the volatility

index options and straddle options are equally well in terms of hedging effectiveness.

Model misspecification has a large impact on the performance of different hedging

6
strategies. It is particularly important to use correctly specified model to value and

calculate the hedging parameters for the target option.

The remainder of the paper is organized as follows. Section 2 provides a brief

review of the option pricing models considered. Section 3 describes the simulation setup

and the hedging strategies employed. Section 4 presents the hedging results. And section

5 concludes.

2 Option Pricing Models

In this section, we review the models used to price and hedge various options. The Black-

Scholes model and the Ornstein-Ulenbeck (OU) stochastic volatility model are employed

for pricing/hedging the exotic options, the plain-vanilla European, and straddle options.

The Whaley (1993) and Grübichler and Longstaff (1996) (GL) models are used for the

pricing/hedging of volatility index options. For simplicity, the risk-free interest rate r is

assumed to be constant, and the underlying asset pays no dividends.

2.1 Option Pricing Models

2.1.1 Black-Scholes Model

The Black-Scholes (1973) model assumes that the underlying asset price S follows a

geometric Brownian motion under the risk neutral probability measure:

dS / S = rdt + σdw (1)

where σ is the volatility of the underlying asset, and is assumed to be constant, and w is

a standard Brownian motion.

7
 In this model, barrier, lookback and standard European options can be priced

analytically. The price of a European option maturing at time T with strike price X,

C (t , S ,σ , X ) , is given by

C (t , S ,σ , X ) = SN (d1 ) − Xe− r (T − t ) N (d 2 ) (2)

where N(·) is the cumulative standard normal probability distribution function, and

ln(S / X ) + (r + 0.5σ 2 )(T − t )

d1 = , d 2 = d1 − σ T − t .
σ T −t

For the exact description of the price formulas of barrier and lookback European options,

we refer the reader to Hull (2001).

2.1.2 Stochastic Volatility Model

Since the path breaking contribution by Black and Scholes (1973) was published, many

papers have tried to relax its stringent assumptions. In particular, the introduction of a

stochastic volatility has been considered by many authors (see, Hull and White (1987),

Heston (1993), among others).

In this paper we consider a stochastic volatility model where the volatility v

follows a mean-reverting OU process. Namely, under the risk neutral probability

measure, the underlying asset price and volatility processes are as follows:

dS / S = rdt + vdw,
(3)
dv = k (θ − v)dt + σdz ,

where k , θ , σ are the speed of adjustment, long-run mean, and volatility of volatility

parameters, respectively; w and z are standard Brownian motions with a correlation

coefficient ρ .

8
 This model is conceptually similar to Heston’s (1993) model where the variance

is specified as a mean reverting square-root process. Like the Heston’s model, this model

can allow for systematic volatility risk and is analytically tractable for pricing plain-

vanilla European options.

For a European call option written on the asset with strike price X and maturity T,

using Ito’s lemma and standard arbitrage arguments, Schöbel and Zhu (1999) showed the

price C (t , S , v, X ) is given as:

C (t , S , v, X ) = SP1 − Xe − r (T − t ) P2 , (4)

where Pj ( j = 1, 2. ) are probabilities which can be calculated using the following

formula:

1 1
∞
⎡ e − iφ ln( X ) f j (t , T , S , v;φ ) ⎤
Pj = + ∫ Re ⎢ ⎥dφ ,
2 π 0 ⎢⎣ iφ ⎥⎦

and f j are the characteristic functions of Pj respectively, and are given in Appendix.

Exotic and straddle options will be valued using a numerical method since there

are no closed form formulas for them in this model.

2.2 Volatility Option Pricing Models

2.2.1 Whaley (1993) Model

Whaley (1993) assumes that the volatility index follows a Geometric Brownian process

similar to equation (1) in which S is replaced with v. For a European call option written

on the volatility index maturing at T with a strike X, its price, C (t , v, X ) , at time t is given

by

C (t , v, X ) = e − r (T − t ) [vN (d1 ) − XN (d 2 )] , (5)

9
where v volatility index level at time t, and

ln(v / X ) + 0.5σ 2 (T − t )
d1 = , d 2 = d1 − σ T − t .
σ T −t

2.2.2 Grübichler and Longstaff (1996) (GL) Model

Grübichler and Longstaff (1996) assume that under the risk neutral probability measure

the volatility index, v, follows the following process

dv = k (θ − v)dt + σ v dz , (6)

where k , θ , σ are constants, and z is a standard Brownian motion.

The price of a European call option on the volatility index v with strike price X

and maturity date T, C (t , v, X ) , is expressed as

C (t , v, X ) = e− ( r + k )(T −t )vQ(αX ; β + 4, λ )
(7)
+ e− r (T −t )θ (1 − e− k (T −t ) )Q(αX ; β + 2, λ ) − e− r (T −t ) XQ(αX ; β , λ ),

where Q( z; x, y ) is the complementary non-central chi-square distribution function

evaluated at z , with x degrees of freedom and non-central parameter y, and

4k 4kθ
α= , β = 2 , λ = αe − k (T − t ) v.
σ (1 − e
2 − k (T − t )
) σ

2.3 Straddle Option Pricing Models

Brenner, et al. (2001) first proposed a new volatility instrument, a straddle option that can

be used to hedge the volatility risk. A straddle involves buying a call and a put with the

same strike price and expiration date. A straddle option is a contract that gives the holder

the right to buy an at-the-money straddle with a strike X STO at time T1 . The straddle

10
matures at time T2 (T2 > T1 ) and has a strike S (T1 )e r (T2 −T1 ) . The payoff of such a contract

at maturity T1 depends, not only on the asset price, but also on the expected volatility

between T1 and T2 . Therefore, it is more exposed to changes in volatility levels. Brenner,

et al. (2001) derive the price formulas for straddle options in both the deterministic

volatility and the stochastic volatility cases and document that the values of these options

are indeed very sensitive to volatility changes. As a result, changes in volatility could be

effectively hedged by this type of option.

2.3.1 Case 1: Straddle Options and Deterministic Volatility Model

In this case, the underlying asset price S is assumed to follow a geometric Brownian

motion similar to what is described in equation (1) except that σ is assumed to be a

mean-reverting deterministic volatility function, i.e.,

dσ = k (θ − σ )dt ,

where k and θ are the speed of adjustment and long-run mean, respectively. The price

of a straddle option is given by

STOt = αSN (d ) − X STO e − r (T1 − t ) N (d − σ 1 T1 − t ), (8)

where σ 1 is the average volatility over the time period between time t and T1 , and σ 2 is

the average volatility between time T1 and T2 , and

2
α= σ 2 T2 − T1 ,
2π

ln(αS / X STO ) + (r + 0.5σ 12 )(T1 − t )

d= .
σ 1 T1 − t

11
2.3.2 Case 2: The Straddle Options and Stochastic Volatility (SV) Model

In this model the asset price is assumed to follow the process given by equation (3).

Brenner, et al. (2001) further assume that ρ = 0 and derive a price formula for straddle

options in this case. However, it is widely documented in empirical studies that the asset

price is typically negatively correlated with the volatility. To obtain sensible results and

to give straddle options a fair chance in the comparison, we assume a non-zero

correlation between the asset price and the volatility. Since the closed-form prices of

straddle options are not available, the vegas of these options are calculated through

numerical methods in this case.

3 Research Methodologies

3.1 Hedging Strategies

To illustrate the hedging procedure, we consider the case where an option trader writes

one option (target option) with value of Ct and relies on the delta-vega hedging strategy

to hedge against both the price and the volatility risks inherent to this position. At time t,

a hedging portfolio is constructed. The portfolio consists of a short position in the hedged

option Ct , at units of the underlying asset St , bt units of another option CtE (instrument

option), and Bt units of the risk-free asset. The value of this portfolio at time t, π t , is

thus

π t = −Ct + at St + bt CtE + Bt .

It is self-financing and delta-vega neutral if

π t = 0,

12
 ∂π t ∂C ∂C E
= − t + at + bt t = 0,
∂St ∂St ∂St

∂π t ∂C ∂C E
= − t + bt t = 0.
∂σ t ∂σ t ∂σ t

Therefore, the hedge parameters are

∂Ct ∂Ct ∂CtE ∂CtE ∂Ct ∂CtE

at = − / , bt = / , Bt = Ct − at St − bt CtE . (9)
∂St ∂σ t ∂σ t ∂St ∂σ t ∂σ t

Assuming a rebalancing interval of ∆t , the value of the hedging portfolio at time t + ∆t

is

π t + ∆t = −Ct + ∆t + at St + ∆t + bt CtE+ ∆t + Bt (1 + r∆t ). (10)

This is the hedging error resulting from using the hedging instrument and the hedge

parameters implied by a particular model (or models) over the rebalancing interval. We

record the hedging error π t + ∆t and reconstruct the self-financing portfolio at the same

time. This procedure continues until the hedged option matures. The average dollar

hedging error (ADHE) and average absolute hedging error (AAHE) are defined as

follows

1 N
ADHE = ∑ π t + i∆t ,
N i =1
(11)

1 N
AAHE = ∑ π t +i∆t ,
N i =1
(12)

where, N is the number of hedging errors recorded. The ADHE measures the average

losses (or profits) of the hedging portfolio over the rebalancing interval, while the AAHE

can be interpreted as a measure of the variability of the hedging errors over the

rebalancing interval.

13
 To make the hedging errors comparable across various moneyness-maturity

groups of options being hedged, researchers (see e.g., Carr and Wu (2002), and Green

and Figlewski (1999), among others) often standardize the hedging errors by dividing

them by the value of the option at the inception. In other words, the percentage ADHE

and AAHE are defined as

%ADHE = ADHE/Ct ,

%AAHE = AAHE/Ct .

If the model is correctly specified and the hedging portfolio is rebalanced

frequently, the hedging error should be very small. For this reason, ADHE and AAHE

can be used as indicators of hedging effectiveness.3

We consider two different hedging strategies:

Strategy 1 (S1): The hedging instrument is a plain-vanilla European option.

Strategy 2 (S2): The hedging instrument is a volatility option.

Also, in strategy 2 (S2), we further investigate the performance of two types of volatility

options: volatility index call options (Strategy S2A) and straddle call options (Strategy

S2B).

For each strategy, we focus on the case where all options are correctly priced in

the market while the hedging parameters are calculated from a particular model. The

models used to calculate the hedging parameters are either correctly specified or

misspecified. When the model is misspecified, its parameters are implied from the correct

option prices. In total, there are 8 cases. In strategies S1 and S2B, either Black-Scholes

3
Another measure of hedging accuracy is the variance or the standard deviation of the hedging errors.
However, as noted by Fan et al. (2002), it could lead to flawed conclusions because the reduced variance
may come at the cost of large systematic biases that can lead to significant losses in hedging.

14
model or the stochastic volatility (SV) model is used to calculate the Greeks of the

hedged options and of the European/straddle options. In strategy S2A, the Greeks of the

hedged options are calculated using either the Black-Scholes model or the stochastic

volatility model, whereas the deltas of the volatility options are computed using either the

Whaley’s model or the GL model.

In contrast to previous studies, in this paper, we consider exotic options such as

barrier and lookback options as the hedged instruments. Barrier and lookback options are

two of the most popular types of exotic options traded in the over-the-counter market.

Their payoffs depend not only on the final asset price but also on the whole path of the

underlying asset price during the option’s life, and therefore they are more sensitive to

volatility risk and model risk than plain-vanilla options. This is especially true for up-

and-out call options since they are cancelled when they are in-the-money (see Davydov

and Linetsky (2001)). As an example, we focus on up-and-out call and lookback options.

An up-and-out call option resembles a standard call option except that the payoff

becomes zero when the underlying asset price reaches a certain barrier level during the

option’s life. A lookback call/put gives the option holder the right to buy/sell at the

lowest/highest price recorded during the option’s life.

The barrier level of the up-and-out call is set equal to 1.2 times of the initial

underlying asset price. To examine the effect of the time-to-maturity of the exotic

options, we consider three different maturities: short-term (30 days to maturity), medium-

term (60 days to maturity), and long-term (90 days to maturity). For up-and-out options,

we also consider different moneyness levels: in-the-money ( S / X = 1.1 ), at-the-money

( S / X = 1.0) , and out-of-the-money ( S / X = 0.9).

15
 As pointed out by Grübichler and Longstaff (1996), longer-maturity volatility

options have little or no value as hedging instruments since their prices are not affected

by changes in volatility. This can be seen from equation (7). As T − t increases, the delta

of the volatility call decreases. For this reason, we choose at-the-money volatility options

with 40 days to maturity in strategy S2A. Consequently, hedges must be rolled over for

medium- and long- term exotic options.4

Regarding straddle options, Brenner, et al. (2001) document that the sensitivities

of their values to changes in volatility decrease as both the strike and the time to maturity

increase. Therefore, we consider approximately at-the-money options with 40 days to

maturity and the underlying straddle maturity is 60 days.

The purpose of this analysis is to examine which hedging strategy is most

effective for the various types of exotic options. To gauge how severe model risk can be,

we compare the performance of the hedging strategies based on a true model with those

based on a misspecified model. Towards this end, the hedging approach is applied to each

model and each exotic option being hedged.

The hedging error depends clearly on the rebalancing frequency as shown in

equation (10). To examine the effect of the rebalancing frequency, rebalancing will be

done on both daily and weekly bases and transaction costs are ignored.

3.2 The Simulation Design

Market prices of exotic and volatility options are not available because exotic options are

traded in the over-the-counter market, while the trading of volatility options in organized

4
Psychoyios and Skiadopoulos (2004) examine the performance of both the roll-over and no-roll-over
strategies and conclude that the former strategy performs better than the latter one. Therefore, we only
consider the roll-over strategy in this paper.

16
exchanges has not yet been instituted until now. To get around this data problem, we use

Monte Carlo simulation methods in this paper.

We assume that the true data generating processes of the underlying asset price

and the volatility index are given by equations (3) and (6), respectively. Namely, the OU

stochastic volatility model is the true model for valuing the exotic options, plain-vanilla

European options, and straddle options while the GL model gives the correct value for

the volatility index options. For hedging purposes, we also need to simulate a time series

of daily underlying asset price under the true probability measure. To go from the true

processes to the risk-neutral processes of (3), Schöbel and Zhu (1999) assume that the

market price of volatility risk, Φ v , is proportional to the volatility, i.e. Φ v = ςv , where

ς ∈ [0,+∞) is a constant parameter. As a result, the processes of the underlying asset

price and the volatility under the true probability measure have the same forms as those

under the risk-neutral measure. They are given as:

dS / S = µdt + vdwt ,
(13)
dv = k * (θ * − v)dt + σdzt ,

where, k * = k − ς , and θ * = kθ /(k − ς ).

In each simulation, we generate a time series of daily asset price according to the

discretized version of equation (13). To obtain option prices and calculate the hedging

ratios, we also generate paths of the daily asset price and the volatility according to

discretized risk neutral processes of equations (3) and (6), respectively. The initial values

of S and v are set to 100 and 0.2, respectively. Other parameter values are: µ = 0.1,

k = 4, θ = 0.15, ς = −1, r = 0.05, σ 2 = 0.133, ρ = −0.5. 5 We simulate 1 year of daily

5
These parameter values are the same as those used in Psychoyios and Skiadopoulos (2004).

17
data, and the underlying asset price is monitored once per day to determine whether the

barrier level is reached or whether a minimum/maxmium has been achieved. The total

number of simulation runs is set to 1000.

4 Hedging Results

4.1 Hedging Effectiveness: Plain-Vanilla Options Versus Volatility Options

We first assess the relative hedging effectiveness of hedging strategies S1 and S2. The

purpose is to see whether volatility index and straddle options are preferred to European

options for hedging volatility risk.

The average absolute and dollar hedging errors for different hedging strategies

and different groups of barrier options are reported in Table 1. Based on the ADHEs,

several observations can be made. First, the SV model performs better than the BS model

in strategies S1 and S2B, whereas the SV-GL outperforms all others in strategy S2A.

This is expected because the SV and GL models are assumed to be the true models.

Second, S1 SV outperforms both S2A SV-GL and S2B SV for hedging short-term

options, but performs poorer than S2A SV-GL and S2B SV for hedging medium- and

long-term options. If the models used are misspecified, the results show a similar pattern

in general. The difference in the hedging errors between the two hedging strategies S1

and S2 is more pronounced for at-the-money and out-of-the-money options. Overall, the

volatility options are more effective than the European options for hedging medium- and

long-term barrier options, but less effective for hedging short-term ones. The reason for

this is that the barrier feature is much more important for a long-term barrier option than

it is for a short-term option because there is a greater probability for the barrier level to be

18
reached in the long term. In other words, long-term options are more “exotic”, and

therefore they are more sensitive to volatility changes. The implication of this finding is

that volatility options are particularly useful vehicles to hedge options with severe exotic

feature, but may not be superior to European options to hedge others.

Third, the performance of any given hedging strategy also clearly depends on the

time-to-maturities and moneyness levels of the hedged options. In general, the hedging

errors for the out-of-the-money options are significantly larger than those for the in-the-

money options. The results suggest that the in-the-money options are easier to hedge than

the out-of-the-money ones regardless of the hedging strategy and time-to-maturity of the

target option. This finding is in line with Figlewski and Freund (1994) and Jiang and

Oomen (2001) where the hedged options are European style. The effect of time-to-

maturity of the hedged option on the performance depends on its moneyness level. In

general, short-term in-the-money options are easier to hedge than long-term in-the-money

options. On the other hand, for at-the-money and out-of-the-money options, hedging

errors decrease with their maturities.

The ADHEs tell us similar stories except that volatility options are better than

European options even for hedging short-term options. The ADHES are particularly large

for out-of-the money options in strategy 1, indicating that European options should not be

used to hedge these options.

The hedging results for the lookback call and put options are reported in Table 2.

Based on the AAHEs, we see that it is more effective to use European options than

volatility options to hedge short-term lookback calls and puts. However, volatility options

are generally better for hedging medium- and long-term lookback options. This is more

19
pronounced for medium- and long-term lookback puts. In addition, lookback calls are

easier to hedge than lookback puts. Based on the ADHEs, the volatility options

outperform the European options generally, in hedging all types of lookback options.

To investigate the effect of rebalancing frequency on the relative performance of

the different hedging strategies, we consider the case where the hedging portfolios are

rebalanced weekly as well. The hedging performance with a lower frequency of hedge

rebalancing provides a more stringent test of the extent to which the dynamic process of

the underlying asset price (or volatility) is embedded in the model than that with a higher

frequency of hedge rebalancing. Tables 3 and 4 report the results. It is not surprising to

notice that the AAHEs are lager than those in the case of the daily rebalancing.

Therefore, the performance of any hedging strategy deteriorates as the rebalancing

frequency decreases. The results also reconfirm the general findings regarding the

relative performance of different strategies in the case of daily rebalancing. However, the

differences in the hedging errors between S1 and S2 are larger especially for the long-

term exotic options.

4.2 Hedging Effectiveness: Straddle Versus Volatility Index Options

In this section, we focus on the Strategy 2 and examine the relative hedging effectiveness

of different volatility options by comparing the performance of volatility index options

(S2A) with that of straddle options (S2B). From the hedging results for barrier options in

Table 1, we can see that straddle options are slightly better than volatility index options in

terms of both AAHEs and ADHEs, and the differences in the hedging errors between

them are less than 2%. This is true for all types of options except for the case of short-

20
term out-of-the-money options, where the difference in AAHEs is more than 4%. The

results in Table 3 suggest that the differences do not increase much when the hedging

portfolios are rebalanced weekly.

Looking at Table 2 and considering lookback call options, the differences in the

hedging errors between the two strategies are negligible. For hedging put options, S2B is

slightly better than S2A for short-term options, but slightly worse for medium- and long-

term options. As in the case of hedging barrier options, a decrease in rebalancing

frequency does not significantly increase the differences in the hedging errors between

S2A and A2B.

Overall, the choice between volatility index and straddle options as hedging

instruments has a negligible impact on the hedging performance.

4.3 Hedging Effectiveness: Impacts of Model Errors

This section evaluates the impacts on hedging performance when a misspecified model is

used to compute the hedging parameters. This issue has been studied extensively in the

literature (see, for example, An and Suo (2004), Jiang and Oomen (2001)), and it is

widely documented that the hedging performance depends greatly on the model used.

Following Psychoyios and Skiadopoulos (2004), we focus on strategy S2 to see the effect

of model error on the hedging effectiveness when the volatility options are used as the

hedging instruments. Specifically, we examine the hedging performance of BS-W, BS-

GL, and SV-W relative to the true combination of SV-GL in S2A and the performance of

BS relative to SV in S2B. The model error arises when a misspecified model is used to

compute the hedge ratio of the exotic option or the volatility option. As SV-GL is the true

21
combination, the hedging errors of SV-GL are only from the discrete adjustments to the

hedge. For other model combinations, the hedging errors would arise from both the

model misspecifications and the discrete adjustments to the hedge.

Based on the hedging results for the barrier options in Table 1, we can see that in

strategy S2A, the performance of the Whaley’s model is comparable to, but slightly

poorer than the performance of the GL model. However, the Black-Scholes model

performs much poorer than the SV model. Overall, BS-GL performs worst among all the

cases. Therefore, when exotic options are hedged with volatility options, there is no need

to use complex volatility option pricing models but it is much important to use more

realistic exotic option pricing models. Similarly, in strategy S2B, the Black-Scholes

model generates larger hedging errors than the SV model.

The impact of model misspecification on the hedging performance for the barrier

options also depends on the moneyness and time-to-maturity of the hedged option. The

differences in the hedging errors are larger for short-term options than for long-term

options, and are larger for out-of-the-money options than for in-the-money options. This

implies that the hedge of short-term and out-of-the-money options is particularly

sensitive to model error.

Table 2 shows that the hedging errors for the lookback call options increase

(sometimes even decrease) slightly when misspecified models are used. For hedging

lookback put options, however, using correct option pricing model proves to be very

important. S2A SV-W and SV-GL perform equally well and they are much better than

S2A BS-W and BS-GL. The difference in the hedging errors is maximized for short-term

lookback puts.

22
 The above results hold for the case of the weekly rebalancing. However, the

hedging errors of S2A BS-W/GL are larger than those of S2A SV-W/GL in this case,

indicating that the impact of model misspecification on the hedging effectiveness

increases as rebalance frequency decreases.

5 Conclusions

This paper investigates three important issues regarding volatility risk hedging. First, we

examine whether volatility options are more effective hedging instruments than plain-

vanilla options in terms of hedging volatility risk. Second, we study the relative hedging

performance of the volatility index options and the straddle options. Finally, we

investigate the effect of model risk on the hedging effectiveness when the volatility

options are used as the hedging instruments. We focus on exotic options like barrier and

lookback options rather than European options as the target options.

Using Monte Carlo simulation and based on the average absolute hedging errors

(AAHEs) and the average dollar hedging errors (ADHEs), our results indicate that plain-

vanilla European options are more effective than volatility options when short-term

exotic options are hedged, however they are less effective when medium- or long-term

options are hedged. This implies that it is particularly important to use volatility options

as hedging instruments to hedge options with an important exotic feature. Volatility index

options perform equally well with straddle options in terms of hedging volatility risk.

We also find that the impact of misspecification of the SV model as the Black-

Scholes model is larger than that of misspecification of the GL volatility model as the

23
Whaley’s model. The Whaley’s model can be reliably used to calculate the hedge

parameters when volatility options are used to hedge volatility risk.

24
References

1. An, Y., and W. Suo, 2004, The Performance of Option Pricing Models in

Hedging Exotic Options, Working Paper, University of Windsor.

2. Black, F., and M. Scholes, 1973, The Pricing of Options and Corporate

Liabilities, Journal of Political Economy, 81, 637-659.

3. Brenner, M., E. Ou, and J. Zhang, 2001, Hedging Volatility Risk, Working Paper,

New York University.

4. Brenner, M., and D. Galai, 1989, New Financial Instruments for Hedging

Changes in Volatility, Financial Analysts Journal (July/August), 61-65.

5. Carr, P., and L. Wu, 2002, Static Hedging of Standard Options, Working Paper,

New York University.

6. Davydov, D., and V. Linetsky, 2001, Pricing and Hedging Path-Dependent

Options under the CEV Process, Management Science, 47, 949-965.

7. Fan, R., A. Gupta, and P. Ritchken, 2002, Hedging in the Possible Presence of

Unspanned Stochastic Volatility: Evidence from Swaption Markets, Working

Paper, Case Western Reserve University.

8. Green, T. C., and S. Figlewski, 1999, Market Risk and Model Risk for a Financial

Institution Writing Options, Journal of Finance, 54, 1465-1499.

9. Grübichler, A., and F. A. Longstaff, 1996, Valuing Futures and Options on

Volatility, Journal of Banking and Finance, 20, 985-1001.

10. Heston, S. (1993), A Closed Form Solution for Options with Stochastic Volatility

with Application to Bond and Currency Options, Review of Financial Studies, 6,

327-343.

25
11. Hull, J., Options, Futures, and Other Derivatives, Prentice Hall, Fifth Edition.

12. Hull, J., and A. White, 1987, The Pricing of Options with Stochastic Volatilities,
Journal of Finance, 42, 281-300.
13. Hull, J., and W. Suo, 2002, A Methodology for Assessing Model Risk and its

Application to the Implied Volatility Function Model, Journal of Financial and

Quantitative Analysis, 37, 297-318.

14. Psychoyios, D., and G. Skiadopoulos, 2004, Volatility Options: Hedging

Effectiveness, Pricing, and Model Error, Working Paper, University of Warwick.

15. Jiang, G., and R. Oomen, 2001, Hedging Derivatives Risks: A Simulation Study,

Working Paper, University of Warwick.

16. Schöbel, R., and J. Zhu, 1999, Stochastic Volatility with an Ornstein-Uhlenbeck

Process: An Extension, European Finance Review, 3, 23-46.

17. Whaley, R. E., 1993, Derivatives on Market Volatility: Hedging Tools Long

Overdue, Journal of Derivatives (Fall), 71-84.

26
Appendix

The Characteristic Functions in Equation (4)

The characteristic functions f j ( j = 1, 2) in equation (4) are given by:

1 ⎡ v2 ⎤ 1
f1 = exp{iφ (r (T − t ) + ln S ) − (1 + iφ ) ρ ⎢ + σ (T − t )⎥ + D(t , s1 , s3 )v 2
2 ⎣σ ⎦ 2

+ B(t , s1 , s2 , s3 )v + E (t , s1 , s2 , s3 )} ,

where

1 1 ⎛ 2k ρ ⎞ (1 + iφ )kθρ 1 (1 + iφ ) ρ
s1 = − (1 + iφ ) 2 (1 − ρ 2 ) + (1 + iφ ) ⎜1 − ⎟ , s2 = , s3 = ,
2 2 ⎝ σ ⎠ σ 2 σ

and

1 ⎡ v2 ⎤ 1
f 2 = exp{iφ (r (T − t ) + ln S ) − iφρ ⎢ + σ (T − t )⎥ + D(t , sˆ1 , sˆ3 )v 2
2 ⎣σ ⎦ 2

+ B(t , sˆ1 , sˆ2 , sˆ3 )v + E (t , sˆ1 , sˆ2 , sˆ3 )} ,

with

1 1 ⎛ 2k ρ ⎞ iφ kθρ 1 iφρ
sˆ1 = φ 2 (1 − ρ 2 ) + iφ ⎜ 1 − ⎟ , sˆ2 = , sˆ3 = .
2 2 ⎝ σ ⎠ σ 2 σ

The functions D, B, E in f j are given by

1 ⎛ sinh(γ 1 (T − t )) + γ 2 cosh(γ 1 (T − t )) ⎞
D (t , s1 , s3 ) = ⎜k − γ1
2 ⎜
⎟,
σ ⎝ cosh(γ 1 (T − t )) + γ 2 sinh(γ 1 (T − t )) ⎟⎠

1 ⎛ (kθγ 1 − γ 2 γ 3 ) + γ 3 [sinh(γ 1 (T − t )) + γ 2 cosh(γ 1 (T − t ))] ⎞

B (t , s1 , s 3 ) = − ⎜⎜ kθγ 1 − ⎟⎟,
σ γ1 ⎝
2
cosh(γ 1 (T − t )) + γ 2 sinh(γ 1 (T − t )) ⎠

1 1
E (t , s1 , s3 ) = − ln[cosh(γ 1 (T − t )) + γ 2 sinh(γ 1 (T − t ))] + k (T − t )
2 2

27
 k 2θ 2 γ 12 − γ 32 ⎛ sinh(γ 1 (T − t )) ⎞
− ⎜⎜ γ 1 (T − t ) − ⎟
2σ 2 γ 13 ⎝ cosh(γ 1 (T − t )) + γ 2 sinh(γ 1 (T − t )) ⎟⎠

(kθγ 1 − γ 2 γ 3 )γ 3 cosh(γ 1 (T − t )) − 1
+ ,
σ 2 γ 13 cosh(γ 1 (T − t )) + γ 2 sinh(γ 1 (T − t ))

with

1
γ 1 = 2σ 2 s1 + k 2 , γ 2 = (k − 2σ 2 s3 ), γ 3 = k 2θ − s 2 σ 2 .
γ1

28
 Table 1

Hedging Errors for Barrier Options

This table reports the hedging errors for each hedging strategy and for each category of
up-and-out call options. The hedging portfolios are rebalanced daily. ITM, ATM, and
OTM stand for in-the-money, at-the-money, and out-of-the-money, respectively. S1, S2,
BS, SV, W, and GL respectively stand for hedging strategy 1, hedging strategy 2, the
Black-Scholes model, the stochastic volatility model, the Whaley’s model, and the
Grübichler and Longstaff Model. Panel A reports the average absolute hedging errors
(AAHEs), and Panel B reports the average dollar hedging errors (ADHEs).

Panel A: AAHEs (%)

Maturity Short-Term Medium-Term Long-Term
Moneyness ITM ATM OTM ITM ATM OTM ITM ATM OTM
S1 BS 0.52 1.68 18.46 2.17 4.33 14.35 3.04 5.52 14.47
SV 0.17 0.76 8.59 1.52 3.06 12.24 1.49 2.68 8.16
BS-W 0.44 2.76 21.16 1.11 2.23 5.96 1.23 1.97 3.87
S2A BS-GL 0.44 2.77 21.32 1.65 3.30 8.83 2.43 3.92 7.71
SV-W 0.23 2.74 16.75 0.73 1.79 6.16 1.01 1.74 4.33
SV-GL 0.21 2.71 16.39 0.65 1.64 5.60 0.91 1.55 3.70
S2B BS 0.24 2.76 16.67 0.78 1.86 6.44 1.07 1.83 4.59
SV 0.21 2.26 13.79 0.66 1.54 5.49 0.82 1.41 2.95
Panel B: ADHEs (%)
Maturity Short-Term Medium-Term Long-Term
Moneyness ITM ATM OTM ITM ATM OTM ITM ATM OTM
S1 BS -0.02 -0.06 -0.58 0.09 0.16 0.54 0.12 0.21 0.62
SV 0.00 -0.02 0.68 0.06 0.13 0.50 -0.01 -0.04 -0.55
BS-W 0.03 0.05 -0.14 0.06 0.10 0.23 0.04 0.06 0.09
S2A BS-GL 0.03 0.05 -0.18 0.10 0.16 0.35 0.12 0.16 0.23
SV-W -0.00 -0.01 -0.09 0.02 0.04 0.16 0.02 0.01 0.06
SV-GL -0.00 -0.01 -0.07 0.02 0.05 0.15 0.02 0.03 0.07
S2B BS 0.01 0.02 0.09 0.00 0.07 0.33 -0.02 0.03 0.09
SV -0.01 0.01 -0.02 0.02 0.04 0.17 0.01 0.01 0.07

29
 Table 2
Hedging Errors for Lookback Options

This table reports the hedging errors for each hedging strategy and for each category of
lookback call and put options. The hedging portfolios are rebalanced daily. S1, S2, BS,
SV, W, and GL respectively stand for hedging strategy 1, hedging strategy 2, the Black-
Scholes model, the stochastic volatility model, the Whaley’s model, and the Grübichler
and Longstaff Model. Panel A reports the average absolute hedging errors (AAHEs), and
Panel B reports the average dollar hedging errors (ADHEs).

Panel A: AAHEs (%)

Maturity Short-Term Medium-Term Long-Term
Moneyness Call Put Call Put Call Put
S1 BS 2.35 3.29 1.19 3.65 1.14 3.43
SV 1.04 2.17 0.79 2.70 0.67 2.36
BS-W 2.38 4.77 1.23 2.53 0.90 1.68
S2A BS-GL 2.39 4.82 1.71 3.73 1.47 3.28
SV-W 2.65 3.29 1.37 1.72 0.92 1.11
SV-GL 2.67 3.31 1.32 1.73 0.81 1.11
S2B BS 2.25 3.78 1.93 3.94 1.59 2.73
SV 2.24 2.94 1.22 1.80 0.67 1.12
Panel B: ADHEs (%)
Maturity Short-Term Medium-Term Long-Term
Moneyness Call Put Call Put Call Put
S1 BS 0.08 0.26 0.08 -0.15 0.07 0.25
SV -0.04 0.11 -0.01 -0.28 0.02 0.01
BS-W -0.06 -0.08 -0.07 -0.08 -0.07 -0.07
S2A BS-GL -0.07 -0.09 -0.08 -0.13 -0.09 -0.14
SV-W -0.04 0.04 -0.04 -0.01 -0.04 -0.01
SV-GL -0.04 0.04 -0.03 -0.01 -0.02 -0.01
S2B BS 0.03 0.08 -0.07 -0.07 -0.06 -0.06
SV 0.01 0.03 -0.03 -0.04 -0.02 0.02

30
 Table 3
Hedging Errors for Barrier Options

This table reports the hedging errors for each hedging strategy and for each category of
up-and-out call options when the hedging portfolios are rebalanced weekly. ITM, ATM,
and OTM stand for in-the-money, at-the-money, and out-of-the-money, respectively. S1,
S2, BS, SV, W, and GL respectively stand for hedging strategy 1, hedging strategy 2, the
Black-Scholes model, the stochastic volatility model, the Whaley’s model, and the
Grübichler and Longstaff Model. Panel A reports the average absolute hedging errors
(AAHEs), and Panel B reports the average dollar hedging errors (ADHEs).

Panel A: AAHEs (%)

Maturity Short-Term Medium-Term Long-Term
Moneyness ITM ATM OTM ITM ATM OTM ITM ATM OTM
S1 BS 0.87 3.58 36.95 3.14 6.51 20.00 4.87 8.86 21.83
SV 0.52 2.52 41.37 2.89 5.77 27.09 4.41 7.43 26.42
BS-W 1.04 7.20 49.54 2.33 4.83 12.53 2.49 4.05 7.86
S2A BS-GL 1.06 7.21 49.93 3.48 7.13 18.43 4.97 8.08 15.60
SV-W 0.55 7.26 44.46 1.51 3.86 13.06 2.05 3.46 8.61
SV-GL 0.55 7.29 44.88 1.52 3.87 13.21 2.05 3.47 8.68
S2B BS 0.61 6.94 49.16 2.56 6.84 17.78 4.89 6.28 16.75
SV 0.59 7.07 38.52 1.78 4.11 13.63 2.16 3.74 8.22
Panel B: ADHEs (%)
Maturity Short-Term Medium-Term Long-Term
Moneyness ITM ATM OTM ITM ATM OTM ITM ATM OTM
S1 BS 0.12 0.21 -0.73 0.31 0.49 1.77 0.30 0.39 0.38
SV 0.01 -0.02 0.46 0.24 0.49 1.30 0.24 0.35 -0.39
BS-W 0.18 0.28 -0.67 0.21 0.31 0.80 0.15 0.16 0.21
S2A BS-GL 0.19 0.27 -0.90 0.38 0.57 1.26 0.45 0.57 0.70
SV-W 0.02 0.07 0.95 0.01 0.03 0.44 -0.06 -0.10 -0.09
SV-GL 0.03 0.04 0.68 0.04 0.08 0.44 0.01 0.01 0.02
S2B BS 0.08 0.28 0.95 -0.09 0.23 0.79 -0.16 -0.17 -0.31
SV 0.04 0.09 0.86 0.10 0.10 0.38 0.05 -0.10 0.05

31
 Table 4
Hedging Errors for Lookback Options

This table reports the hedging errors for each hedging strategy and for each category of
lookback call and put options when the hedging portfolios are rebalanced weekly. S1, S2,
BS, SV, W, and GL respectively stand for hedging strategy 1, hedging strategy 2, the
Black-Scholes model, the stochastic volatility model, the Whaley’s model, and the
Grübichler and Longstaff Model. Panel A reports the average absolute hedging errors
(AAHEs), and Panel B reports the average dollar hedging errors (ADHEs).

Panel A: AAHEs (%)

Maturity Short-Term Medium-Term Long-Term
Moneyness Call Put Call Put Call Put
S1 BS 4.26 7.75 3.17 6.99 2.44 6.81
SV 3.48 5.51 2.06 4.62 1.61 3.92
BS-W 5.95 11.30 2.68 5.31 1.72 3.35
S2A BS-GL 5.94 11.44 3.83 7.84 3.09 6.57
SV-W 6.28 8.90 2.87 4.05 1.76 2.45
SV-GL 6.29 8.95 2.83 4.06 1.66 2.45
S2B BS 7.31 8.43 2.71 5.67 2.58 4.77
SV 6.31 8.04 2.59 3.51 1.48 2.17
Panel B: ADHEs (%)
Maturity Short-Term Medium-Term Long-Term
Moneyness Call Put Call Put Call Put
S1 BS 0.19 0.57 0.54 1.06 0.19 1.31
SV -0.22 0.48 -0.24 -0.14 0.13 0.03
BS-W 0.29 0.23 -0.14 -0.18 -0.19 -0.20
S2A BS-GL 0.25 0.28 -0.16 -0.29 -0.21 -0.41
SV-W -0.28 0.21 -0.21 0.03 -0.17 0.01
SV-GL -0.21 0.17 -0.18 -0.02 -0.10 -0.01
S2B BS -0.47 -0.23 -0.32 -0.24 -0.25 -0.45
SV 0.28 0.25 0.14 0.29 0.07 0.16

32

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