Hi guys!One question regarding this kind of option... consider a baasket option when the underlying is a basket of mutual funds (in case, for example, of a unit-linked product): no problem with the pricing of course, but how can be this option hedged if I cannot trade those mutual funds? I mean, what's the best hedging strategy to implement (excluding, I suppose, Delta hedging)?Thanks!Ima

Do you know the "real time" composition of those funds. If so then i dont think that its so difficult to find the answer!!!Its much easier also if you pick index funds that claim to track some index, albeit you are left with some managerial/tracking error/basis risk.

Suppose you do not know the real-time composition... and often no composition at all because this piece of information is usually disclosed once a month - or even more seldom...I don't think it's so easy to get hedged... you think so?

In the case of index tracking funds assuming that there are assigned to the same index (thus you diversify some of the tracking error) then the methodology is identical to an index option.If the basket of funds is composed by funds tracking various indices then the keyword is cross hedging. dont you think?

Cross-hedging would be fine... but it's effectiveness depends strictly upon correlation, or not?Next question: if the basket is allowed to change over time as a consequence of active asset allocation, is cross-hedging still a good proxy? I guess so... what about you?

----------Cross-hedging would be fine... but it's effectiveness depends strictly upon correlation, or not?----------------No, in the minimum variance hedge technique it depends upon your portfolio's beta with the index or index future you will use to hedge, but you need to find the most robust and least volatile relationship. Do you have any better idea than this?---------Next question: if the basket is allowed to change over time as a consequence of active asset allocation, is cross-hedging still a good proxy? I guess so... what about you? --------------The allocation of funds within your basket is time varying or the allocation of stocks within each fund? In other words who is the active allocator? You, the basket composer, or the fund managers? In any case you are giving yourself a hard time

QuoteNo, in the minimum variance hedge technique it depends upon your portfolio's beta with the index or index future you will use to hedge, but you need to find the most robust and least volatile relationship. Do you have any better idea than this?No better idea... in case of funds tracking approximately an index I think cross-hedging is fine, even though we have to deal with funds that are just a proxy of the index, and so this could mean a rough hedging... [it's better to be roughly unhedged than perfectly mishedged - Taleb ]QuoteThe allocation of funds within your basket is time varying or the allocation of stocks within each fund? In other words who is the active allocator? You, the basket composer, or the fund managers? In any case you are giving yourself a hard time Very hard time... the point is: imagine I'm the writer of the option, next we have fund manager who actively picks stocks for his own mutual fund and the last one involved is a fund-of-funds manager who actively manages the fund-picking which is my underlying basket. How to hedge my position? Things getting worse and worse and worse...

First you can compose the basket in such a way that minimises the historical tracking error. Its a simple LP problem.In the second case of actively managed funds, i cant see any reason why you should do it. Whats your objective?

My aim is to keep the option in my portfolio and at the same time to be fully hedged...Another way [trivial] is to buy it from another client in order to offset my position gaining/loosing the spread, if any... I thought "plain-vanilla" basket options were more easy to manage, but I'm no more sure about that...In case of managed funds, why did you say there is no reason to do it? If the underlying is changing with time I think something has to be done otherwise my portfolio has a strong risky bias - having sold the option... or not?

-----------My aim is to keep the option in my portfolio and at the same time to be fully hedged...----------------Fully hedged means that the position earns the risk free return. Since none is presses you to take long (because only long positions you can have as a share holder in a mutual fund) position in a fund, then you have no need to be hedged. just invest in risk free securities.-----------In case of managed funds, why did you say there is no reason to do it? If the underlying is changing with time I think something has to be done otherwise my portfolio has a strong risky bias - having sold the option... or not?-------------The only reason i can think is the one of a bet between the fund's return and benchmark return. This spread clearly reflects active management skills. But this bet can be done quite easily with futures as well. There is no need to torture yourself by engineering such basket options Eventually think about transaction costs and management fees

I was trying to get deeper inside an IB position... in partucular, this basket option could be part of a "capital guaranteed" wrapped product: ZCB + basket option (with mutual funds as underliyng). I was wondering how an IB who sells the option could behave: is it goin' to keep the option unhedged in its portfolio, partially hedged or fully hedge? And then, if it decides to cover its position, how to implement such a hedging?I was not so much accustomed with baskets, so I asked for tips... and the idea of cross-hedging (with index futures I suppose) looks fine... but I was also wondering how it can be re-engineered, of course just if any re-engineering is possible...

of interest to you guys: (?)http://netec.mcc.ac.uk/WoPEc/data/Paper ... fr/~busca/ Talks/2002/bachelier.pdfhttp://netec.mcc.ac.uk/WoPEc/data/Papers/ wpawuwpfi9801001.htmlmake sure you are loged on to www.wilmott.com:http://www.wilmott.com/310/today_detail.cfm?articleID=68

I'll have a look... thanks Collector for letting me know...

QuoteEventually think about transaction costs and management fees Anthis, what about this? How can mgmt fees and costs be involved? Could you give me some hints?

You can buy and sell mutual funds like any other underlying. Therefore, a bank can become delta neutral quite easily with most decent and liquid mutual funds. Any decent institution will have a very big say in the choice of funds on which it writes a basket option, i.e. constraints on size of fund, cash component, and any choice of replacement index in the event the fund is closed for any reason. The real issue is hedging the vega risk. If the mutual funds are equity based then it is relatively straightforward to find combinations of equity indices that track the mutual fund and you can use to hedge the vol. Let's say someone else in the bank will sell you an option on a basket of indices to the same maturity as the option you have sold to the client. You have matched your vega , more or less, and now all that is left is to manage the tracking risk between the index basket and mutual fund basket which arises due to having to dynamically hedge separately each half of the position. This is the art of the business and where things can get messy.OPtions on bond mutual funds are trickier. A secondary question is whether there are options on bond indices available, I am not aware of any kind of liquid market in these. Which usually leads to equity traders wanting to mess with bond and interest rate options, usually not a good idea!