Arbitrage Pricing and Risk-Neutral Probabilities
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This Chapter reviews some basic elements from asset-pricing theory thus establishing the theoretical foundations of the techniques presented in this book. First, we explain the principles of arbitrage pricing of financial derivatives.’ The most important implication for our purpose is that derivative prices can be expressed as conditional expectations by transforming the probability measure for the stochastic process of the underlying asset prices. This result can be derived by a replication argument that shows how the pay-off function of the derivative can be replicated by an appropriate portfolio of stocks and bonds.
KeywordsOption Price Market Model Call Option Price Process Standard Brownian Motion
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