P. Carr and L. Wu: Static Hedging of Standard Options

November 12, 2002

We consider the hedging of options when the underlying assetprice is exposed to the possibility ofjumps of random size. Working in a single factor Markovian setting, we derive a new, static spanningrelation between a given option and a continuum of shorter-term options written on the same asset.We implement this static relation using a finite set of shorter-term options and use Monte Carlosimulation to determine the hedging error. We compare this hedging error to that of a delta hedgingstrategy based on daily rebalancing in the underlying futures.