Volatility misspecification, option pricing and superreplication via coupling

Abstract

Consider the performance of an options writer who misspecifies the dynamics of the price process of the underlying asset by overestimating asset price volatility. When does he overprice the option? If he follows the hedging strategy suggested by his model, when does the terminal value of his strategy dominate the option payout?

We show that both these events happen if the option payoff is a convex function of the price of the underlying at maturity. The proofs involve the simple, powerful and intuitive techniques of coupling.