Maximum drawdown insurance

Peter Carr, Hongzhong Zhang, Olympia Hadjiliadis

Research output: Contribution to journalArticle

Abstract

The drawdown of an asset is a risk measure defined in terms of the running maximum of the asset's spot price over some period [0, T]. The asset price is said to have drawn down by at least $K over this period if there exists a time at which the underlying is at least $K below its maximum-to-date. We introduce insurance against a large realization of maximum drawdown and a novel way to hedge the liability incurred by underwriting this insurance. Our proposed insurance pays a fixed amount should the maximum drawdown exceed some fixed threshold over a specified period. The need for this drawdown insurance would diminish should markets rise before they fall. Consequently, we propose a second kind of cheaper maximum drawdown insurance that pays a fixed amount contingent on the drawdown preceding a drawup. We propose double barrier options as hedges for both kinds of insurance against large maximum drawdowns. In fact for the second kind of insurance we show that the hedge is model-free. Since double barrier options do not trade liquidly in all markets, we examine the assumptions under which alternative hedges using either single barrier options or standard vanilla options can be used.

Original languageEnglish (US)
Pages (from-to)1195-1230
Number of pages36
JournalInternational Journal of Theoretical and Applied Finance
Volume14
Issue number8
DOIs
StatePublished - Dec 2011

Keywords

  • Drawdown
  • drawup
  • static replication

ASJC Scopus subject areas

  • Finance
  • Economics, Econometrics and Finance(all)

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