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list1
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basic on no arbitrage pricing

June 10th, 2016, 2:46 pm

QuoteOriginally posted by: DocToclist1, not sure what you mean. BUT, in general you price something by how you can hedge it i.e. eliminating the market risk. if you understand cash and carry args then why are you trying to re-invent the wheel?An instrument that is governed by GBM is an example of the basic instrument that can not be hedged. Possibility to present a perfect hedge is a sufficient condition to state that a particular price represents a perfect hedge. It is not a necessary condition to state that stochastic market uses this particular price. Next moment after buying an instrument no arbitrage price can lead to loss or gain. This is an example alternative to hedge defined price. If a big institution comes to derivatives it make sense to follow no arbitrage pricing concept. But if individual investors like a hedge fund buying a derivative I think that their intention similar to a gambler who comes in casino. They wish to make money and their strategy is based on P/L , which deals with market risk characteristics. In a low volatility markets like listed forwards all strategies are probably present close values and therefore one can claim that market pricing follows unique hedging concept. Nevertheless in volatility market such options market the distinctions between perfect hedging pricings and one that is implied by P/L can be quite visible. I think that this remark can be easy verify by using binomial scheme. We should calculate binomial BS-type price and then to find the option median distribution price. Similarly it can be done in continuous setting too. Doing so one can try to find out whether historical data close to BS or visibly deviates from the benchmark. I talked about median but if market predicts up or down P/L -price can be biased too. Cash-and-carry is an example of the hedged pricing concept.
 
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DocToc
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basic on no arbitrage pricing

June 10th, 2016, 2:50 pm

ok - are you just asking about why a hedge fund would buy or sell a particular derivative and how they would come to this conclusion?
 
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list1
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basic on no arbitrage pricing

June 10th, 2016, 3:00 pm

QuoteOriginally posted by: DocTocok - are you just asking about why a hedge fund would buy or sell a particular derivative and how they would come to this conclusion?No , I just drawed a thought that they probably do not use hedging concept buying and selling. For them I am not absolutely positive hedging does not a dominating intention. Though your point on"why a hedge fund would buy or sell a particular derivative and how they would come to this conclusion" should be interesting. From my subjective point no arbitrage pricing is a pointwise law. It is theoretical pricing concept that deals with a particular moment of time. At next moment the pricing exposure can be significantly changed. P/L pricing approach covers an interval of time during which risiky instrument is considered for pricing.
 
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DocToc
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Joined: January 20th, 2010, 9:32 am

basic on no arbitrage pricing

June 10th, 2016, 3:20 pm

so I think there are three things you are asking..1. You are asserting that hedge funds ignore cash and carry type args? that cannot be true.2. You want to know how hedge funds determine that there is value in a particular trade? there are a multitude of ways.3. prices are changing all the time? this is true.================================================I think you are confusing price and value. I am not a buy side participant BUT with them in my experience, they usually have a view. Whether it is because of the weather, what they ate for breakfast, the news or some statistical model beats me. As a sell side participant your bread and butter (mostly) comes from showing these people prices (i.e. a market). Therefore as long as you can capture enough of the spread that you show them and hedge yourself you have done ok. Broadly, the key difference in my opinion is, the sell side participant should have theoretically hedged himself and therefore doesn't care where the price goes from trading.The hedge fund on the other hand is fully aware of the price (as they are in the business of ripping off, not getting ripped off) but it is their view that the value is different from the price (in this sense the contract is mispriced) and thus if they are correct, the price should somewhat align with their view of the value over time.As to actual strategies I have no idea, but I would definitely say that it can be more complicated than an equation. Otherwise I would almost surely start off my own fund from my kitchen to find these interesting opportunities.
 
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list1
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basic on no arbitrage pricing

June 10th, 2016, 3:39 pm

DocToc, to use formal talk I wish to say that market pricing or observed historical derivatives prices does not necessary and sufficient follow the hedging concept. One also can recall that when underlying of the derivative does not GBM hedging pricing does not exist. Even diffusion with jump does not have hedge like price. Hence the only case when hedge price of a derivative is defined is only GBM model of underlying. Even when derivative underlying is close to a GBM we can not use BS solution as an estimate of the close underlying as far as the hedge solution of the close underlying is undefined and we can not estimate their difference while P/L estimate of the price still remains valid
Last edited by list1 on June 9th, 2016, 10:00 pm, edited 1 time in total.