A New Set of Financial Instruments

Abstract

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In complete markets there are risky assets and a riskless asset. It is assumed that the riskless asset and the risky asset are traded continuously in time and that the market is frictionless. In this paper, we propose a new method for hedging derivatives assuming that a hedger should not always rely on trading existing assets that are used to form a linear portfolio comprised of the risky asset, the riskless asset, and standard derivatives, but rather should design a set of specific, most-suited financial instruments for the hedging problem. We introduce a sequence of new financial instruments best suited for hedging jump-diffusion and stochastic volatility market models. The new instruments we introduce are perpetual derivatives. More specifically, they are options with perpetual maturities. In a financial market where perpetual derivatives are introduced, there is a new set of partial and partial-integro differential equations for pricing derivatives. Our analysis demonstrates that the set of new financial instruments together with a risk measure called the tail-loss ratio measure defined by the new instrument’s return series can be potentially used as an early warning system for a market crash.

Keywords

• option pricing
• hedging
• Merton’s jump diffusion model
• stochastic volatility model
• tail-loss ratio risk measure