Hedging Errors Induced by Discrete Trading Under an Adaptive Trading Strategy

Abstract

Discrete time hedging in a complete diffusion market is considered. The hedge portfolio is rebalanced when the absolute difference between delta of the hedge portfolio and the derivative contract reaches a threshold level. The rate of convergence of the expected squared hedging error as the threshold level approaches zero is analyzed. The results hinge to a great extent on a theorem stating that the difference between the hedge ratios normalized by the threshold level tends to a triangular distribution as the threshold level tends to zero.