Deep Hedging of Long-Term Financial Derivatives

TL;DR

This paper applies deep reinforcement learning to optimize global hedging strategies for long-term financial derivatives, demonstrating superior performance and adaptability in complex market conditions with jump risks.

Contribution

It introduces an extensive benchmarking of deep hedging policies for long-term derivatives, highlighting the advantages of non-quadratic penalties and neural networks in risk management.

Findings

Non-quadratic hedging significantly reduces downside risk.

Neural networks adapt effectively to different market features.

Deep hedging outperforms traditional benchmarks in complex scenarios.

Abstract

This study presents a deep reinforcement learning approach for global hedging of long-term financial derivatives. A similar setup as in Coleman et al. (2007) is considered with the risk management of lookback options embedded in guarantees of variable annuities with ratchet features. The deep hedging algorithm of Buehler et al. (2019a) is applied to optimize neural networks representing global hedging policies with both quadratic and non-quadratic penalties. To the best of the author's knowledge, this is the first paper that presents an extensive benchmarking of global policies for long-term contingent claims with the use of various hedging instruments (e.g. underlying and standard options) and with the presence of jump risk for equity. Monte Carlo experiments demonstrate the vast superiority of non-quadratic global hedging as it results simultaneously in downside risk metrics two to three times smaller than best benchmarks and in significant hedging gains. Analyses show that the neural networks are able to effectively adapt their hedging decisions to different penalties and stylized facts of risky asset dynamics only by experiencing simulations of the financial market exhibiting these features. Numerical results also indicate that non-quadratic global policies are significantly more geared towards being long equity risk which entails earning the equity risk premium.