OPTION PRICING AND HEDGING WITH TEMPORAL CORRELATIONS

We consider the problem of option pricing and hedging when stock returns are correlated in time. Within a quadratic-risk minimisation scheme with history-dependent hedging strategies, we obtain a general formula, valid for weakly correlated non-Gaussian processes. We show that for Gaussian price increments, the correlations are irrelevant, and the Black-Scholes formula holds with the volatility of the price increments calculated on the scale of the re-hedging. For non-Gaussian processes, further non trivial corrections to the "smile" are brought about by the correlations, even when the hedge is the Black-Scholes Δ-hedge. We introduce a compact notation which eases the computations and could be of use to deal with more complicated models.