Root's Barrier: Construction, Optimality and Applications to Variance Options

18 June 2010
Alexander Cox
"We investigate a construction of a Skorokhod embedding due to Root (1969), which has been the subject of recent interest for applications in Mathematical Finance (Dupire, Carr & Lee), where the construction has applications for model-free pricing and hedging of variance derivatives. In this context, there are two related questions: firstly of the construction of the stopping time, which is related to a free boundary problem, and in this direction, we expand on work of Dupire and Carr & Lee; secondly of the optimality of the construction, which is originally due to Rost (1976). In the financial context, optimality is connected to the construction of hedging strategies, and by giving a novel proof of the optimality of the Root construction, we are able to identify model-free hedging strategies for variance derivatives. Finally, we will present some evidence on the numerical performance of such hedges. (Joint work with Jiajie Wang)"