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Regime-dependent smile-adjusted delta hedging

Authors


Correspondence author, ICMA Centre, Henley Business School at Reading, Whiteknights, Reading RG6 6BA, UK. Tel: +44 (0)1183 786431, Fax: +44 (0)20 8668 6050

Abstract

We introduce several regime-dependent smile-adjusted deltas and compare their efficiency with the smile-adjusted deltas that are popular with option traders. Using math formula years of daily option prices, out-of-sample hedging performance tests for options of all moneyness and maturities and daily, weekly, or fortnightly rebalancing show that even the simplest regime-dependent smile-adjustment consistently outperforms implied BSM delta hedging and local volatility and minimum variance smile-adjustments. Markov-switching deltas offer the best performance, with delta-hedging errors often half the size of implied BSM hedging errors. During volatile markets risk reduction from regime-dependent delta hedging is much greater than during tranquil periods.

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