Hedging under the Heston model with jump-to-default

Peter Carr, Wim Schoutens

Research output: Contribution to journalArticle

Abstract

In this paper, we will explain how to perfectly hedge under Heston's stochastic volatility model with jump-to-default, which is in itself a generalization of the Merton jump-to-default model and a special case of the Heston model with jumps. The hedging instruments we use to build the hedge will be as usual the stock and the bond, but also the Variance Swap (VS) and a Credit Default Swap (CDS). These instruments are very natural choices in this setting as the VS hedges against changes in the instantaneous variance rate, while the CDS protects against the occurrence of the default event. First, we explain how to perfectly hedge a power payoff under the Heston model with jump-to-default. These theoretical payoffs play an important role later on in the hedging of payoffs which are more liquid in practice such as vanilla options. After showing how to hedge the power payoffs, we show how to hedge newly introduced Gamma payoffs and Dirac payoffs, before turning to the hedge for the vanillas. The approach is inspired by the Post-Widder formula for real inversion of Laplace transforms. Finally, we will also show how power payoffs can readily be used to approximate any payoff only depending on the value of the underlier at maturity. Here, the theory of orthogonal polynomials comes into play and the technique is illustrated by replicating the payoff of a vanilla call option.

Original languageEnglish (US)
Pages (from-to)403-414
Number of pages12
JournalInternational Journal of Theoretical and Applied Finance
Volume11
Issue number4
DOIs
StatePublished - Jun 2008

Fingerprint

Jump
Heston model
Hedge
Hedging
Credit default swaps
Variance swap
Maturity
Stochastic volatility model
Laplace transform
Call option
Heston
Polynomials

Keywords

  • Credit default swap
  • Default
  • Hedging
  • Heston model
  • Orthogonal polynomials
  • Stochastic volatility
  • Variance swap

ASJC Scopus subject areas

  • Economics, Econometrics and Finance(all)

Cite this

Hedging under the Heston model with jump-to-default. / Carr, Peter; Schoutens, Wim.

In: International Journal of Theoretical and Applied Finance, Vol. 11, No. 4, 06.2008, p. 403-414.

Research output: Contribution to journalArticle

Carr, Peter ; Schoutens, Wim. / Hedging under the Heston model with jump-to-default. In: International Journal of Theoretical and Applied Finance. 2008 ; Vol. 11, No. 4. pp. 403-414.
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