The Effects of Volatility Smile on Warrant Hedging and Arbitrage

While the Black-Scholes (BS) model and binomial trees assume that the stock price evolves lognormally with constant volatility, volatility smiles are pronounced in almost all the world equity markets. To study the effects of volatility smiles on hedging and arbitrage, the method based on the BS model and consisted with observed market volatility smiles is proposed. The empirical results indicate that the proposed model can decrease risk exposure and increase profits on hedging compared with the BS model, and make considerable returns on arbitrage-trading in the Taiwan warrant market. The model is useful for warrant issuers attempting to decrease vega risk and practicable for investors implementing as arbitrage strategies under smile effects.