Local parametric analysis of hedging in discrete time

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 tracking error is reduced up to 41% for short-maturity options. The performance can still be improved by combining locally estimated hedge portfolio weights with standard analysis based on historically estimated parameters. The root mean square tracking error is thereby reduced by about 18% for long-maturity options, Plots of the locally estimated volatility parameter against moneyness and maturity reveal the biases of the Black-Scholes model when hedging in discrete time. In particular, there is a sharp 'smile' effect in the relation between estimated volatility and moneyness for short-maturity options, as well as a significant 'wave' effect in the relation with maturity for deep out-of-the-money options. (C) 1997 Elsevier Science S.A.