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FRM Part I · FRM Exam Part I · Exotic Options

Which description best captures static options replication for hedging an exotic option, as opposed to dynamic delta hedging?

Static options replication means holding a portfolio of standard options whose value matches the exotic's along a boundary, such as a barrier, and unwinding it only if that boundary is hit. It avoids continuous rebalancing, unlike dynamic delta hedging.

  1. AHolding a portfolio of standard options that matches the exotic's value along a boundary, and unwinding it only if the boundary is reachedCorrect
  2. BRebalancing the underlying position continuously so that net delta is always zero
  3. CSelling the exotic to another dealer at a fixed spread to avoid any residual exposure
  4. DUsing only futures contracts on the underlying to offset the exotic's gamma

Explanation

In static replication, standard options are chosen so their value equals the exotic's on a boundary, such as the barrier or the expiry-date payoff. The position is not rebalanced and is unwound only if the boundary is hit. Continuous rebalancing describes dynamic hedging.

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