Dilip Madan
Pricing and Hedging Basket Options to Prespecifed Levels of
Acceptability
Stress levels embedded in S&P 500 options are constructed and
reported. The stress function used is MINMAXVAR: Seven joint laws for
the top 50 stocks in the index are considered. The first time changes a
Gaussian one factor copula. The remaining six employ correlated
Brownian motion independently time changed in each coordinate. Four
models use daily returns, either run as L\' evy processes or scaled, to
the option maturity. The last two employ risk neutral marginals from
the VGSSD and CGMYSSD Sato processes. The smallest stress function uses
CGMYSSD risk neutral marginals and L\' evy correlation. Running the L\'
evy process yields a lower stress surface than scaling to the option
maturity. Static hedging of basket options to a particular level of
accept- ability is shown to substantially lower the price at which the
basket option may be offered.