Option Valuation and Hedging Strategies with Jumps in the Volatility of Asset Returns



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    • Faculty of Commerce and Business Administration, University of British Columbia. Financial support from the 1989 Nikko-LOR research competition is gratefully acknowledged. I thank Ruth Freedman, Bryan Routledge, Mark Rubinstein, René Stulz, the editor, and two anonymous referees, for several useful suggestions. I am especially grateful to Raman Uppal for his help. Any remaining errors are mine.


We develop a model in which the volatility of risky assets is subject to random and discontinuous shifts over time. We derive prices of claims contingent on such assets and analyze options-based trading strategies to hedge against the risk of jumps in the return volatility. Unsystematic and systematic events such as takeovers, major changes in business plans, or shifts in economic policy regimes may drastically alter firms' risk profiles. Our model captures the effect of such events on options markets.