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ets on market prices are represented by options (also called "contingent
claims"). Options are replicated using delta hedging. Such point of view is
the basic theory. The complications arise when the contingent claims depend on
non-observable stochastic parameters such as probabilities of default. More
complications arise when there are not enough trading instruments to hedge
against some sources of uncertainty. The subjects of counterparty risk (a
balanced position suddenly goes into red because in-the-money part of the
portfolio disapears due to counterparty default) and liquidity risk (a
position slides into trouble but there is no way to hedge it or get rid of it)
are not yet considered in these notes.
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