Local parametric analysis of hedging in discrete time

Abstract

When continuous-time portfolio weights are applied to a discrete-time hedging problem, errors are likely to occur. This paper evaluates the overall importance of the discretization-induced tracking error. It does so by comparing the performance of Black-Scholes hedge ratios against those obtained from a novel estimation procedure, namely local parametric estimation. In the latter, the weights of the duplicating portfolio are estimated by fitting parametric models (in this paper, Black-Scholes) in the neighborhood of the derivative's moneyness and maturity. Local parametric estimation directly incorporates the error from hedging in discrete time. Results are shown where the root mean square t..