Fundamentals and advanced techniques in derivatives hedging. Translated from the French (Q289665): Difference between revisions

The book covers the foundations of pricing and hedging derivative instruments -- one of the most important area of contemporary mathematical finance. It provides an overview of the methods used in this area: from very fundamental ones to the latest developments. The first two chapters contain a standard presentation of stochastic mathematical models used in pricing derivative financial instruments. Both discrete and continuous models are presented. The authors present also two fundamental theorems of asset pricing and methods of hedging and super-hedging derivative instruments. Unlike in many other textbooks on mathematical finance, the possibility of restrictions on possible investment strategies is also considered. The authors consider cases in which the vector describing the structure of a portfolio should lie in some convex cone or a convex set. For the latter case they provide a dual formulation of the super-hedging problem using the support function of the set of allowed portfolios. At the end of the first part of the book the authors consider non-classical methods of pricing and hedging. They describe pricing with a utility function as well as quantile hedging and hedging based on a loss-function. In the former approach to hedging one minimizes the probability that the hedging strategy fails. In the latter approach, the expected shortfall, measured as expected value of some loss function, is minimized. The authors provide the solutions to both problems using martingale measures. In the second part of the book the authors take a different approach to modelling and formulate pricing and hedging problems using stochastic flows and relationships between stochastic differential equations (SDE) and partial differential equations (PDE). They (i) make use of the Feynman-Kac theorem to state the pricing problem as a PDE, (ii) also consider the case where the price function is only continuous (and not necessarily differentiable) and is a viscosity solution of the appropriate PDE, and (iii) make use of PDE approach to derive a super-hedging strategy in models of incomplete markets and in case there are restrictions on possible strategies. At the end of this part they present a direct approach to the hedging problem using the geometric dynamical programming principle. The authors adapt this approach by solving the super-hedging problem and by the minimization of a loss-function. They also present the technique of face-lift, allowing to simplify the pricing PDE by modifying the payoff function of a derivative instrument. The third part is the most interesting from the point of view of applications. The authors consider two types of models with varying volatilities. In the first one (local volatility models) the volatility is a function of time and/or current prices. In the second one (stochastic volatility models) the volatility is a stochastic process. The authors consider misspecifications of the volatility curve and imperfections connected with the fact that the hedging portfolio cannot be rebalanced continuously. They study the impact of these imperfections on the performance of the hedging strategy. The book covers a rich variety of techniques used in mathematical finance: from the very beginning to recently developed ones. The additional advantage of the book is (i) that it contains many examples that show how to apply this methods to widely-used market models and (ii) that every chapter is accompanied by a series of exercises that can serve as illustrations (the solutions to all of them are provided).