Non-zero risk in the real world
Chapter 2 looked at how an investor might use derivatives to manage risk. In order for the Black–Scholes pricing theory to work, several major assumptions were made about how financial markets behave. This chapter re-visits the whole question of risk and derivatives for real-world markets, without automatically making these assumptions. Consequently, the formalism in this chapter is more complicated than that in Chapter 2: therefore it is presented in a pedagogical manner while emphasizing the practical steps that one needs to take to implement it. The formalism is built upon the landmark work of Bouchaud and Sornette. In addition to discussing the practical implementation of their inherently non-Black–Scholes scheme, the chapter also addresses the crucial issue of managing portfolios in the presence of non-zero transaction costs.
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