Journal of Risk
ISSN:
1465-1211 (print)
1755-2842 (online)
Editor-in-chief: Farid AitSahlia
Power options: hedging nonlinear risks
Robert G. Tompkins
Abstract
ABSTRACT
This paper examines contingent claims where the terminal payoff is defined by a curved function and considers the case of squared power options. These products have been repackaged as continuous strike price options, where the strike price of a European option is softened to reduce nonlinear risk at expiration. Other applications include the ability to hedge future levels of implied volatility and to address a number of other nonlinear risks facing risk managers. The author considers the pricing and hedging of squared power options and shows that either a standard dynamic or a simple static approach with European options can effectively hedge these instruments.
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