Perfect Hedging of Index Derivatives Under a Locally Arbitrage Free Minimal Market Model
AbstractThe paper presents a financial market model that generates stochastic volatility using a minimal set of factors. These factors, formed from transformations of square root processes, model the dynamics of different denominations of a benchmark portfolio. Benchmarked prices are assumed to be local martingales. Numerical results for the pricing and hedging of basic derivatives on indices are described. This includes cases where the standard risk neutral pricing methodology fails. However, payoffs can be perfectly hedged using self-financing strategies and a form of arbitrage still exists. This is illustrated by hedge simulations. The term structure of implied volatilities is documented.
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Bibliographic InfoPaper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 61.
Date of creation: 01 Jun 2001
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derivative pricing; arbitrage; minimal market model;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
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- Platen, Eckhard, 2001.
"A benchmark model for financial markets,"
SFB 373 Discussion Papers
2001,52, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
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