How model risk of Delta hedging is reduced by static hedging
Explain how is exposed model risk of Delta hedging is reduced by static hedging.
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But, on the theoretical side, the model for the underlying is not ideal; at the very least we do not identify parameter values accurately. Delta hedging alone leaves us very exposed to the model, it is model risk. Several of these problems can be eliminated or reduced if we follow a strategy of static hedging and delta hedging; sell or buy more liquid traded contracts to decrease the cash flows in the original contract. There static hedge is put in place now, and left till expiry. In the excessive case where an exotic contract has all of its cashflows matched by cashflows from traded options then its value is specified by the cost of setting up the static hedge; a model is not required. (But then the option wasn’t exotic into the first place.)
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