Local parametric analysis of derivatives pricing and hedging

A novel methodology for the analysis of derivatives pricing in incomplete markets is tested empirically. The methodology generates hedge ratios and derivatives prices. They are estimated from the correlation structure between the local co-movements of securities prices. First, the hedge ratios from a parsimonious complete-market model are estimated by fitting locally the changes in the derivatives and the underlying securities prices. Second, derivatives prices are obtained from the locally estimated hedge ratios. The methodology, referred to as local parametric estimation, is tested on a dataset of DAX index options and futures transactions from the computerized German Futures Exchange. © 2003 Elsevier Science B.V. All rights reserved.