Risk Management for Derivatives in Illiquid Markets: A Simulation Study

Abstract

In this paper we study the hedging of derivatives in illiquid markets. More specifically we consider a model where the implementation of a hedging strategy affects the price of the underlying security. Following earlier work we characterize perfect hedging strategies by a nonlinear version of the Black-Scholes PDE. The core of the paper consists of a simulation study. We present numerical results on the impact of market illiquidity on hedge cost and Greeks of derivatives. We go on and offer a new explanation of the smile pattern of implied volatility related to the lack of market liquidity. Finally we present simulations on the performance of different hedging strategies in illiquid markets.