Hedging Portfolio for a Degenerate Market Model

TL;DR

This paper develops a method to compute hedging portfolios in degenerate market models with singular volatility, using advanced martingale representation and Malliavin calculus, especially for exotic options.

Contribution

It introduces a new approach to derive hedging strategies in degenerate diffusion models using a Clark-Hausmann-Bismut-Ocone type formula and projection techniques.

Findings

Explicit hedging formulas for exotic options

Solution of hedging as a linear system

Demonstration of strategy in degenerate markets

Abstract

We consider a semimartingale market model when the underlying diffusion has a singular volatility matrix and compute the hedging portfolio for a given payoff function. Recently, the representation problem for such degenerate diffusions with respect to a minimal martingale has been completely settled. This martingale representation and Malliavin calculus established further for the functionals of a degenerate diffusion process constitute the basis of the present work. Using the Clark-Hausmann-Bismut-Ocone type representation formula derived for these functionals, we prove a version of this formula under an equivalent martingale measure. This allows us to derive the hedging portfolio as a solution of a system of linear equations. The uniqueness of the solution is achieved by a projection idea that lies at the core of the martingale representation at the first place. We demonstrate the hedging strategy as explicitly as possible with some examples of the payoff function such as those used in exotic options, whose value at maturity depends on the prices over the entire time horizon.