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EdisonCruise
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Posts: 99
Joined: September 15th, 2012, 4:22 am

Is there any practical method to replicate stock index option by index future?

June 29th, 2015, 12:57 am

Suppose the option is on stock index. Since it is difficult to buy or sell stock index, index future is preferred for hedging the option. However, there are some different factors between index future an stock index. For example:1. Volatility. Future?s volatility is usually larger than stock index2. Dividend yield is implied by index future3. Basic risk may be large at certain period4. Usually front month contract of future is traded due to liquidity reason, rolling a future per month can introduce additional tracking error.So, is there any practical method to handle these?Thank you.
 
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Orbit
Posts: 492
Joined: October 14th, 2003, 5:34 pm

Is there any practical method to replicate stock index option by index future?

June 29th, 2015, 2:50 pm

1. Uh, are you quite sure? Maybe the basis will change the volatility, but depending on what assumptions you use to describe this it would be a subtlety.2. Dividend yield is equivalent in the underlying index or the future. SPX is price return. DAX however is different! Check it out. But the future and the index should be defined in an equivalent way to one another, so it should be ok.3. Basis risk is fleeting, especially in a low rate environment.4. Futures rolls are extremely tight in a bid/ask sense.It's all part of the art form.
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