Hedging under the Heston Model with Jump - to - Default 5

In this paper, we will explain how to perfectly hedge under Heston’s stochastic volatility 17 model with jump-to-default, which is in itself a generalization of the Merton jump-todefault model and a special case of the Heston model with jumps. The hedging instru19 ments we use to build the hedge will be as usual the stock and the bond, but also the Variance Swap (VS) and a Credit Default Swap (CDS). These instruments are very 21 natural choices in this setting as the VS hedges against changes in the instantaneous variance rate, while the CDS protects against the occurrence of the default event. 23 First, we explain how to perfectly hedge a power payoff under the Heston model with jump-to-default. These theoretical payoffs play an important role later on in the hedging 25 of payoffs which are more liquid in practice such as vanilla options. After showing how to hedge the power payoffs, we show how to hedge newly introduced Gamma payoffs and 27 Dirac payoffs, before turning to the hedge for the vanillas. The approach is inspired by the Post–Widder formula for real inversion of Laplace transforms. Finally, we will also 29 show how power payoffs can readily be used to approximate any payoff only depending on the value of the underlier at maturity. Here, the theory of orthogonal polynomials 31 comes into play and the technique is illustrated by replicating the payoff of a vanilla call option. 33