The Efficient Hedging Frontier with Deep Neural Networks

TL;DR

This paper introduces the Efficient Hedging Frontier using deep neural networks, integrating filtering and market movement forecasting to optimize hedging strategies with lower costs and risks.

Contribution

It presents a novel framework combining deep learning and filtering to improve hedging strategies and introduces a new recurrent neural network for better cost-risk trade-offs.

Findings

Frontier shifts towards lower costs and risks with market movement forecasting.

Deep neural networks effectively compute hedging strategies on the frontier.

Enhanced strategies achieve improved hedging performance.

Abstract

The trade off between risks and returns gives rise to multi-criteria optimisation problems that are well understood in finance, efficient frontiers being the tool to navigate their set of optimal solutions. Motivated by the recent advances in the use of deep neural networks in the context of hedging vanilla options when markets have frictions, we introduce the Efficient Hedging Frontier (EHF) by enriching the pipeline with a filtering step that allows to trade off costs and risks. This way, a trader's risk preference is matched with an expected hedging cost on the frontier, and the corresponding hedging strategy can be computed with a deep neural network. We further develop our framework to improve the EHF and find better hedging strategies. By adding a random forest classifier to the pipeline to forecast market movements, we show how the frontier shifts towards lower costs and reduced risks, which indicates that the overall hedging performances have improved. In addition, by designing a new recurrent neural network, we also find strategies on the frontier where hedging costs are even lower.