Option hedging

The modelling, pricing and hedging of options is based on risk-neutrality. The concept of risk-neutrality has revolutionised the way options are modelled after it was introduced by Black and Scholes but it gives a false appearance of precision to hedgers. Pricing and hedging options with the Black and Scholes model highlight its limitations through discrepancies between apparently inaccurate changes in the profit and loss account of the option hedger and the expected theoretical changes based on the originally computed option sensitivities. The Monte Carlo simulations in this dissertation have shown that non-normally distributed spot prices, discrete hedging, transaction costs, stochastic volatility and incorrect volatility forecast paired with other market imperfections significantly impact the option pricing and hedging. But hedging has shown to require more attention and more accurate estimations of its parameters. Hedge parameters (such as delta, gamma, vega, d(vega)/d(volatility) and hedging must account for these market imperfections, and bridge the gap between theory and practice of option risk management. For these reasons, option hedging is the subject of this dissertation.