Community Research and Development Information Service - CORDIS

Abstract

Banks trade every day derivatives, financial instruments whose values depend on the behaviour of more basic financial instruments. Complex models are developed to evaluate derivatives (pricing), to quantify the maximum risk that a bank is facing trading these instruments, and to suggest an effective strategy to manage the risk (hedging). The problem of hedging involves the search for one or more contracts to offset the risk incurred by holding a certain contract. The final objective is that of building a portfolio that has minimum risk (ideally risk-less). A number of different hedging strategies can be thought depending on the type of risk that one is willing to offset. For instance the risk associated with changes in the underlying, in its volatility, or both. In this work we analyse the error that arises when hedging a caplet, a particular type of European option, so as to offset the risk due to yield curve movements. The constraint is that only a finite number of trades are allowed. Transaction costs of trading are taken into account. Sensitivity analysis is used to identify the major sources of error among the several factors involved: the number of portfolio revisions needed to maintain the hedging error below a certain threshold under several yield curve evolution scenarios and different assumptions for the transaction costs.

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Additional information

Authors: CAMPOLONGO F, European Commission, Joint Research Centre, Institute for the Protection and the Security of the Citizen, Ispra (IT);ROSSI A, European Commission, Joint Research Centre, Institute for the Protection and the Security of the Citizen, Ispra (IT)
Bibliographic Reference: Oral report given at: 6th International Conference on Probabilistic Safety Assessment and Management (PSAM 6) Organised by: Internat. Assoc. of Prob. Safety Assessm. & Manag. (IAPSAM) Held at: San Juan, Puerto Rico (US), 23-28 June 2002
Record Number: 200214773 / Last updated on: 2002-05-24
Category: PUBLICATION
Original language: en
Available languages: en
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