Market Illiquidities as a Source of Model Risk in Dynamic Hedging

Publication: Chapter in book/Conference proceedingChapter in edited volume


In the present paper we study market illiquidity as a particular source of model risk in the hedging of derivatives. We depart from the usual Black-Scholes framework, where it is assumed that option hedgers are small traders, and consider a model where the implementation of a hedging strategy affects the price of the underlying security. We derive a formula for the feedback-effect of dynamic hedging on market volatility and present a formula for the hedging error due to market illiquidity. We go on and characterize perfect hedging strategies by a nonlinear version of the Black-Scholes PDE. We relate this PDE to other models for the risk-management of derivatives under market frictions and present some simulations.
Original languageEnglish
Title of host publicationModel Risk
Editors Rajna Gibson
Place of PublicationLondon
PublisherRisk Publications
Pages125 - 138
ISBN (Print)1899332898
Publication statusPublished - 1 May 2000

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