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Hedging under the Heston Model with Jump-to-Default

by Peter Carr of Bloomberg LP & Courant Institute of Mathematical Sciences, and
Wim Schoutens of Katholieke Universiteit Leuven

September 21, 2007

Abstract: In this paper we will explain how to perfectly hedge under Heston's stochastic volatility model with jump to default, which is in itself a generalization of the Merton jump-to-default model and a special case of the Heston model with jumps. The hedging instruments 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 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. 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 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 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 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 comes into play and the technique is illustrated by replicating the payoff of a vanilla call option.

JEL Classification: C60.

Keywords: CDS, jump to default, Heston, Hedging, Variance Swaps.

Published in: International Journal of Theoretical and Applied Finance, Vol. 11, No. 4, (June 2008), pp. 403-414.

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