Dynamic hedging of financial instruments when the underlying follows a non-Gaussian process

Abstract

Traditional dynamic hedging strategies are based on local information (ie Delta and Gamma) of the financial instruments to be hedged. We propose a new dynamic hedging strategy that employs non-local information and compare the profit and loss (P&L) resulting from hedging vanilla options when the classical approach of Delta- and Gammaneutrality is employed, to the results delivered by what we label Delta- and Fractional- Gamma-hedging. For specific cases, such as the FMLS of Carr and Wu (2003a) and Merton’s Jump-Diffusion model, the volatility of the P&L is considerably lower (in some cases only 25%) than that resulting from Delta- and Gamma-neutrality