Working Papers

Quantitative Finance

F-series

Date:

Number:CARF-F-348

Optimal Hedging for Fund & Insurance Managers with Partially Observable Investment Flows (Revised version of CARF-F-338; Forthcoming in "Quantitative Finance")

Author:Masaaki Fujii, Akihiko Takahashi

Abstract

All the financial practitioners are working in incomplete markets full of unhedgeable
risk-factors. Making the situation worse, they are only equipped with the imperfect
information on the relevant processes. In addition to the market risk, fund and
insurance managers have to be prepared for sudden and possibly contagious changes
in the investment flows from their clients so that they can avoid the over- as well as
under-hedging. In this work, the prices of securities, the occurrences of insured events
and (possibly a network of) the investment flows are used to infer their drifts and
intensities by a stochastic filtering technique. We utilize the inferred information to
provide the optimal hedging strategy based on the mean-variance (or quadratic) risk
criterion. A BSDE approach allows a systematic derivation of the optimal strategy,
which is shown to be implementable by a set of simple ODEs and the standard Monte
Carlo simulation. The presented framework may also be useful for manufactures and
energy firms to install an efficient overlay of dynamic hedging by financial derivatives
to minimize the costs.

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