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R: Data Analysis and Visualization by Ágnes Vidovics-Dancs, Kata Váradi, Tamás Vadász, Ágnes Tuza, Balázs Árpád Szucs, Julia Molnár, Péter Medvegyev, Balázs Márkus, István Margitai, Péter Juhász, Dániel Havran, Gergely Gabler, Barbara Dömötör, Gergely Daróczi, Ádám Banai, Milán Badics, Ferenc Illés, Edina Berlinger, Bater Makhabel, Hrishi V. Mittal, Jaynal Abedin, Brett Lantz, Tony Fischetti

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Chapter 8. Optimal Hedging

After discussing the theoretical background in the previous chapters, we will now focus on some practical problems of derivatives trading.

Derivatives pricing, as detailed in Daróczi et al. (2013), Chapter 6, Derivatives Pricing, is based on the availability of a replicating portfolio that consists of traded securities that offer the same cash flow as the derivative asset. In other words, the risk of a derivative can be perfectly hedged by holding a certain number of underlying assets and riskless bonds. Forward and futures contracts can be hedged statically, while the hedging of options needs a rebalancing of the portfolio from time to time. The perfect dynamic hedge presented by the Black-Scholes-Merton (BSM) model ...

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