Hedging large risks reduces the transaction costs

9 May 2000

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As soon as one accepts to abandon the zero-risk paradigm of Black-Scholes, very interesting issues concerning risk control arise because different definitions of the risk become unequivalent. Optimal hedges then depend on the quantity one wishes to minimize. We show that a definition of the risk more sensitive to the extreme events generically leads to a decrease both of the probability of extreme losses and of the sensitivity of the hedge on the price of the underlying (the 'Gamma'). Therefore, the transaction costs and the impact of hedging on the price dynamics of the underlying are reduced.

Authors

Farhat Selmi , Jean-Philippe Bouchaud