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Title: Performance of utility-based strategies for hedging basis risk
Authors: Monoyios, M
Issue Date: 2003
Publisher: Brunel University
Citation: Economics and Finance Working papers, Brunel University, 03-13
Abstract: The performance of optimal strategies for hedging a claim on a non- traded asset is analyzed. The claim is valued and hedged in a utility max- imization framework, using exponential utility. A traded asset, correlated with that underlying the claim, is used for hedging, with the correlation typically close to 1. Using a distortion method [30, 31] we derive a non- linear expectation representation for the claim's ask price and a formula for the optimal hedging strategy. We generate a perturbation expansion for the price and hedging strategy in powers of 2 = 1􀀀 2. The terms in the price expansion are found to be proportional to the central moments of the claim payo under a measure equivalent to the physical measure. The resulting fast computation capability is used to carry out a simulation based test of the optimal hedging program, computing the terminal hedg- ing error over many asset price paths. These errors are compared with those from a naive strategy which uses the traded asset as a proxy for the non-traded one. The distribution of the hedging error acts as a suitable metric to analyze hedging performance. We nd that the the optimal pol- icy improves hedging performance, in that the hedging error distribution is more sharply peaked around a non-negative pro t. The frequency of pro ts over losses is increased, and this is measured by the median of the distribution, which is always increased by the optimal strategies.
Appears in Collections:Dept of Economics and Finance Research Papers

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