Discrete time hedging errors for options with irregular payoffs
The authors consider the model of a financial market with a risky asset (a share of price \(X_{t}\) at time \(t\)) and a non risky asset (which price is \(S_{t}\) at time \(t\)). The dynamics of assets are given by the stochastic differential equation \(dX_{t}= \mu(X_{t})X_{t} dt +\sigma(X_{t})X_{t} dB_{t}\) with \(X_0=x_0>0\) and ordinary differential equation \(dS_{t}=rS_{t}dt\). The European vanilla option with the payoff function \(f\) and maturity \(T\) is considered. The price of this option is given by \({\mathbf E}(\exp(-rT)f(X_{T})\mid F_0)\). Let us set \(u(t,x)={\mathbf E}_{x}(\exp(-r(T-t))f(X_{T-t}))\) and let us assume that the investor will trade at \(n\) fixed times in the period \([0,T]\). At each trading time \(t_{k}=kT/n, k=0,\ldots,n\) the trader holds \({\partial u\over\partial x}(t_{k},X_{t_{k}})\) units of the asset \(X_{t}\). At maturity the investor will be left with the difference \(\Delta_{n}(f)=\int_{0}^{T}{\partial u\over\partial x}(t,X_{t}) d\widetilde X_{t}-\int_{0}^{T}{\partial u\over\partial x}(\phi(t),X_{\phi(t)}) d\widetilde X_{t}\), where \(\phi(t)=\sup\{t_{i}\mid t_{i}\leq t\}\), \(\widetilde X_{t}=e^{-rT}X_{t}\). It is known that \(\Delta_{n}(f)\) converges in probability to \(0\) as \(n\to+\infty\). The authors prove that the rate of convergence strongly depends on the regularity properties of \(f\).
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