Empirical Analysis of the Model-Free Valuation Approach: Hedging Gaps, Conservatism, and Trading Opportunities

TL;DR

This paper empirically evaluates the effectiveness of model-free valuation methods for financial derivatives, comparing them to traditional models, and demonstrates how to construct profitable, risk-controlled trading strategies based on these insights.

Contribution

It provides the first empirical analysis quantifying the hedging gaps and conservatism of model-free approaches, and introduces a profitable, risk-controlled trading strategy derived from these findings.

Findings

Model-free hedging is only slightly more conservative than Heston-model-based approaches.

The study quantifies the empirical gap between payoff and hedging strategies.

A profitable trading strategy with explicit downside risk control is constructed.

Abstract

In this paper we study the quality of model-free valuation approaches for financial derivatives by systematically evaluating the difference between model-free super-hedging strategies and the realized payoff of financial derivatives using historical option prices from several constituents of the S&P 500 between 2018 and 2022. Our study allows in particular to describe the realized gap between payoff and model-free hedging strategy empirically so that we can quantify to which degree model-free approaches are overly conservative. Our results imply that the model-free hedging approach is only marginally more conservative than industry-standard models such as the Heston-model while being model-free at the same time. This finding, its statistical description and the model-independence of the hedging approach enable us to construct an explicit trading strategy which, as we demonstrate, can be profitably applied in financial markets, and additionally possesses the desirable feature with an explicit control of its downside risk due to its model-free construction preventing losses pathwise.