Gap risk KVA and repo pricing

Wujiang Lou introduces a reserve capital approach to the hedging error in the BSM model

A hand measuring a gap with a ruler

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The theory of option pricing derives from the construction of a trading portfolio in the underlying stock and money market investment. It is constructed such that the option is dynamically hedged. A short call option on a stock modelled after a geometric Brownian motion, for example, can be self-financed and replicated perfectly so there is no hedging error. The option and its hedging portfolio, therefore, contribute zero market risk capital. When the stock price is

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