DOI 10.1007/s11147-006-9003-1 Calibration and hedging under jump diffusion

Abstract A jump diffusion model coupled with a local volatility function has been suggested by Andersen and Andreasen (2000). By generating a set of option prices assuming a jump diffusion with known parameters, we investigate two crucial chal-lenges intrinsic to this type of model: calibration of parameters and hedging of jump risk. Even though the estimation problem is ill-posed, our results suggest that the model can be calibrated with sufficient accuracy. Two different strategies are explored for hedging jump risk: a semi-static approach and a dynamic technique. Simulation experiments indicate that each of these methods can sharply reduce risk exposure