Hedge backtesting for model validation


Pricing and hedging is easy, in theory. The existence of arbitrage-free prices is equivalent to the existence of martingale measures, and there are ways of constructing replication strategies via the martingale representation theorem and the Clark-Ocone formula (see, for example, Harrison & Pliska, 1981, and Musiela & Rutkowski, 2005).

Arbitrage-free prices can also be obtained as solutions to certain partial differential equations (PDEs) (see, for example, Harrison & Pliska, 1981, and Black &

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