A Semi-Dynamic Approach for Valuing and Hedging Options on Two Assets with Continuous Payout

S.-J. Deng (USA, PRC)

Keywords

Semidynamic hedging, options pricing, spread options, spark spread, electricity derivatives, real options.

Abstract

A central problem in risk management is how to de velop effective and accurate hedging strategies for fi nancial and physical assets which are usually not liq uidly traded in the market. We consider the problem of replicating the payoffs of options on two assets with a fixed finite maturity which continuously pay out cash flows.We propose an alternative approach for pricing and hedging these options, which combines dynamic trading in the underlying assets with static positions in a set of basket options of one single maturity. In mar kets where the amount of financial instruments required for implementing effective hedging strategies is large but the number of liquidly traded instruments is small such as the case with electricity markets, this approach presents a promising alternative for hedging long-term financial/physical assets with underlying commodities and a set of standardized options of one or several ma turity times. It helps in identifying a standardized set of hedging instruments, which reduces the need for trading with a large variety of financial instruments and focuses the trading in the chosen set of securities, thus increasing the trading liquidity of the chosen instruments as well as the hedging efficiency.

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