Dynamic Hedging Under Jump Diffusion with Transaction Costs

If the price of an asset follows a jump diffusion process, the market is in general incomplete. In this case, hedging a contingent claim written on the asset is not a trivial matter, and other instruments besides the underlying must be used to hedge in order to provide adequate protection against jump risk. We devise a dynamic hedging strategy that uses a hedge portfolio consisting of the underlying asset and liquidly traded options, where transaction costs are assumed present due to a relative bid-ask spread. At each rebalance time, the hedge weights are chosen to simultaneously (i) eliminate the instantaneous diffusion risk by imposing delta neutrality; and (ii) minimize an objective that is a linear combination of a jump risk and transaction cost penalty function. Since reducing the jump risk is a competing goal vis-à-vis controlling for transaction cost, the respective components in the objective must be appropriately weighted. Hedging simulations of this procedure are carried out, and our results indicate that the proposed dynamic hedging strategy provides sufficient protection against the diffusion and jump risk while not incurring large transaction costs.