On the hedging of options on exploding exchange rates (Q471173)

The authors propose to modify the notion of a contingent claim price in the setting where the source of uncertainty is a strict local martingale rather than a martingale. They propose to use the minimal cost for superreplicating a given contingent claim under two probability measures simultaneously as a pricing operator for contingent claims. The main result provides a formula for the minimum joint superreplication cost in a complete market. This approach restores a put-call parity and international put-call equivalence for model prices. The novelty is a rigorous justification of the pricing formula as a hedging cost. As to the mathematical tools, the Föllmer measure for nonnegative local martingales is constructed extending the corresponding results for strictly positive local martingales. A stochastic calculus for the suggested change of measure is developed in which neither measure dominates the other one. The authors' approach uses two numéraires simultaneously, which requires to introduce the notions of market completeness and superreplication. Numerous examples are provided.