The Boy’s Guide to Pricing and Hedging Essay

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T here is an unfortunate strain of pedantry running through the teach- ing of quantitative finance, one in- volving an excess of abstraction, formality, rigour and axiomatisation that makes the subject unnecessarily daunting and diffi- cult. Over the years I’ve seen a few too many resh graduates who, on being asked why one believes one can obtain a cred- ible value for an option, reply that it’s be- cause of Girsanov’s theorem. I’d like to think most of the useful as- pects of quantitative finance are relative- ly simple, and so, here is my rather abbreviated poor man’s guide to the field. Price and value You must first distinguish between price and value. Price is what you pay to acquire a security; value is what it is worth. The price is fair when it is equal to the value. But what is the value? How do you es- timate it? Judging value, in even the sim- plest way, involves the construction of a model or theory. The one and only commandment of quantitative finance According to legend, Hillel, a famous sage, was asked to recite the essence of God’s laws while standing on one leg. “Do not do unto others as you would not have hem do unto you,” he is supposed to have said. “All the rest is commentary. Go and learn.” You can summarise the essence of quantitative finance on one leg too: “If you want to know the value of a securi- ty, use the price of another security that’s as similar to it as possible. All the rest is modelling. Go and build.” The wonderful thing about this law, when compared with almost everything else in economics, is that it dispenses with utility functions, those unobservable hid- den variables whose ghostly presences permeate economic heory. But don’t hink you can escape all human perceptions by using this law; the models of

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