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Suppose an exotic European option has a sub hedging (price being lower than the target) portfolio of vanilla European options all with the same expiry as the exotic option. The sub hedging portfolio dynamically depends on the market condition. Suppose the exotic option market price is now below the sub hedging vanilla portfolio and the market is fully liquid and frictionless (no bid-ask spread and other transaction cost). We would like to capture the arbitrage opportunity by longing the exotic option and shorting its sub hedging option portfolio. The question is if we continually adjust our hedge holding according to the current sub hedging portfolio as the time rolls forward? Are there any papers on this subject?

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    $\begingroup$ I find this a bit too generic question. How is the exotic quoted ? Is it OTC ? What spread are we talking about ? What kind of exotic is that.... etc $\endgroup$ – Ezy Mar 6 at 3:19
  • $\begingroup$ @Ezy: It is generic. Let us assume the market is frictionless (no bid-ask spread). More importantly, I would like to ask for some references on this subject. $\endgroup$ – Hans Mar 7 at 8:18
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    $\begingroup$ Your question is so generic that I would suggest you just try to google "sub-hedging strategies" and post whatever you come up with that you like as an answer to your own question. Unless someone has done specific research on the topic here, you're not going to get a better answer. $\endgroup$ – Raskolnikov Mar 7 at 13:16
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    $\begingroup$ Also, in perfect market conditions (no friction, completeness, etc...) I suspect one would go for a hedging strategy immediately instead of sub- or super-hedging. I suspect the natural context to consider sub-hedging is when one can't rely on simplifying market assumptions. $\endgroup$ – Raskolnikov Mar 7 at 13:19

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