Option hedging error in commodity markets

Hedging options are a common practice to reduce or specify the risk of an option position. In most institutions, it takes place daily. The hedge coefficients used are often determined by the Black Scholes option pricing model and are commonly referred to as the “greeks”. Although the flaws of the Black Scholes model are well known, the model is still extremely useful and the most commonly used approach. The hedge error is defined as the difference in the profit and loss of the option position and the hedge position. Hedging an option reduces the volatility of an option position. In practice, the volatility of the position cannot be reduced to zero. This thesis studies the remaining volatility known as hedge error. This thesis examines how moneyness and tenor affect hedge error in order to help a trader manage the hedge error. Secondly, this thesis investigates which subset of the greeks provides an optimal and economically significant reduction in volatility. Corn, lean hogs, and crude oil are the three commodities that are investigated in this thesis. The results are additionally separated into puts and calls. The results show that as an option is further out-of-the-money, the hedge error increases by an economically significant amount. Second, this research finds only marginal volatility reduction is achieved by hedging rho, interest rate risk. However, incorporating a gamma and/or vega hedge significantly reduces the volatility of the option portfolio returns.

Name thesis:degree_name

M.S.

Level thesis:degree_level

Thesis

Discipline thesis:degree_discipline

Agricultural & Applied Econ

Grantor

University of Illinois at Urbana-Champaign

Year dc:date

2021

Author dc:creator

• Olson, Ryan Paul

Contributors dc:contributor

• Sherrick, Bruce J
• Robe, Michel A
• Garcia, Philip

• Options, Hedging, Financial Engineering, Agricultural Economics

Statement dc:rights

• 2020 by Ryan Paul Olson. All rights reserved

Language dc:language

en

Handle dc:identifier

http://hdl.handle.net/2142/109434

OAI identifier oai:identifier

oai:www.ideals.illinois.edu:2142/109434