Dynamic Hedging In Incomplete Markets: A Simple Solution

Despite much work on hedging in incomplete markets, the literature still lacks tractable dynamic hedges in plausible environments. In this paper, the authors provide a simple solution to this problem in a general incomplete-market economy in which a hedger, guided by the traditional minimum-variance criterion, aims at reducing the risk of a non-tradable asset. They derive fully analytical optimal hedges and demonstrate that they can easily be computed in various stochastic environments. Their dynamic hedges preserve the simple structure of complete-market perfect hedges and are in terms of generalized "Greeks," familiar in risk management applications, as well as retaining the intuitive features of their static counterparts.