Nicos Christofides

The classical approach to the pricing and hedging of derivative instruments involves the construction and trading of a portfolio of basic assets so as to replicate the possible derivative payoffs.  The whole approach is based on the no-arbitrage principle.  In many markets, however, such replication is not always possible (the market is incomplete) either because of jumps in the underlying price process, (as is the case with pricing credit derivatives) or because the underlying cannot be traded in the quantities needed (because of liquidity restrictions), or for a variety of other reasons.  In such cases, the arbitrage considerations alone can only provide upper and lower bounds on the option price - not an exact value.  The talk will develop the "pseudo-arbitrage" and "near-arbitrage" arguments which can form a sufficient basis for an exact pricing methodology.  Computational pricing comparisons for some credit derivatives will be given.