QuoteOriginally posted by: TinManI'm definitely interested.QuoteOriginally posted by: frenchX What I believe in is a combination of S(VM)² and UVM. Basically is a bit like fusionning SV and UVM. You will have a best case/worst case for the mean and the variance. You can imagine the worst value being mean_worst-eps*worst_variance and the best one being mean_best+eps*best_variance. Delta is choosen for each to cancel the directional risk and to minimize the variance. Then you built a static hedge to reduce your spread between best case/ worst case. Once you have that, you sell your exotic to your reduce best case (seller case) or you can buy it for your reduced worst case (buyer side). To agree with the market you can play a bit with eps (your risk aversion) to evaluate your loss.Once you have sell your exotic, you have to hedge it. Hedging can only be done discretely at one cost. The hedging model is very similar to the pricing one except that there is no continuous delta hedging. The underlying is seen as a call option with 0 strike and is incorporated in the semi static hedging. Being mark to market, this static hedging includes transaction costs even for the underlying.In your notation, P (the pricing model)=H (the hedging one)+continuous time delta hedga-transaction costs for the underlyingFor me in pricing model you assume perfect delta hedging so it will be a upper bound (statistically I mean) of the hedging model.Have you implemented an example of this?Oh, and interesting choice of words, 'I believe in'.....There's no point in replacing one faith based method with another, empiricism is what counts.Yes I will try to do that. I insist on the word "try" because first I'm far from being a computer genius in programming and second I don't have plenty of time (I'm writing my thesis at the moment) but it's worth to try. If you have an explicit soft for Heston model (or general stoch vol) with explicit euler (the classical one), the modification is easy. For the estimation of the parameters, the method described in the book of Paul is easy and efficient (with fokker planck).And for the believe word, it's more intuition than faith There are a lot of articles with very fancy pricing models which perform poorly in terms of hedging (a paper from Carol Alexander which show that the smile adjusted BS formula is better than Heston, or a paper about pricing with non normal distribution whose hedging is worse than classical BS).I could be wrong but not sure. The best would be to do an internship or a postdoc about that on that topic.
Last edited by frenchX
on May 9th, 2011, 10:00 pm, edited 1 time in total.