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Radon Series on Computational and Applied Mathematics 7

Managing Editor
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Editors
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 Radon Series on Computational and Applied Mathematics

1 Lectures on Advanced Computational Methods in Mechanics

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2 Gröbner Bases in Symbolic Analysis
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6 Iterative Regularization Methods for Nonlinear Ill-Posed Problems
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 Jan H. Maruhn

Robust Static Super-Replication

of Barrier Options

≥
Walter de Gruyter · Berlin · New York
 Keywords
Static hedging, barrier options, robust optimization, stochastic volatility,
semi-infinite optimization, semidefinite programming.

Mathematics Subject Classification 2000

49-02, 91-02, 91B28, 90C30, 90C34, 91B24.

앪
앝 Printed on acid-free paper which falls within the guidelines
of the ANSI to ensure permanence and durability.

ISBN 978-3-11-020468-1

Bibliographic information published by the Deutsche Nationalbibliothek

The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie;
detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.

쑔 Copyright 2009 by Walter de Gruyter GmbH & Co. KG, 10785 Berlin, Germany.
All rights reserved, including those of translation into foreign languages. No part of this book
may be reproduced or transmitted in any form or by any means, electronic or mechanical,
including photocopy, recording, or any information storage or retrieval system, without permission
in writing from the publisher.
Printed in Germany
Cover design: Martin Zech, Bremen.
Printing and binding: Hubert & Co. GmbH & Co. KG, Göttingen.
To Sylvia
Preface

Since the ground-breaking work of Black and Scholes it is common practice to

hedge exotic options by dynamically adjusting portfolio positions based on the sensi-
tivities (Greeks) of the target option. However, while this works sufficiently well in
practice for instruments with well-behaved sensitivities, it may be impossible to dy-
namically hedge options with discontinuous payoff profile and hence wildly moving
Greeks. Motivated by this problem as well as the idea to avoid a continuous adjustment
of the portfolio positions, the concept of static trading strategies has been developed in
the literature.
Due to the fact that barrier options are components of a variety of products traded in
the market, various authors have focussed on the static hedging of barrier options with
discontinuous payoff profile like up-and-out calls. For these options, a static trading
strategy consists of buying a portfolio of standard calls and holding this portfolio con-
stant until either the barrier option expires or the barrier is hit. In the latter case of a
barrier hit at some time in the future, the portfolio of calls is liquidated and hopefully
provides a payoff equal to the value of the up-and-out call.
As the future value of the calls changes with the volatility surface, it is intuitively
clear that a static hedging strategy has to be robust against changes of this surface.
However, this key property has so far not been throroughly adressed in the literature,
because considering the dynamics of the volatility surface leads to analytical and com-
putational difficulties.
The book at hand closes this gap by developing an optimization approach which
combines the idea of static hedging with the concept of super-replication and finally
adds robustness against movements of the volatility surface in the sense of a worst case
design. The resulting robust static hedging problem is analyzed in detail from a the-
oretical and numerical point of view. This analysis draws from the fields of financial
mathematics, stochastic and semi-infinite optimization, convex analysis, partial differ-
ential equations as well as semidefinite optimization, to derive appropriate existence,
duality and convergence results.
Detailed examples show that the proposed static hedging framework is superior to
the approaches developed in the literature. In particular the computed robust static
hedging strategies prevent potentially huge losses due to changes of the volatility sur-
face and only consist of a small number of liquidly traded standard options. Surpris-
ingly, the robustness can be gained by relatively little additional cost. Moreover, in
contrast to other approaches the computations prove to be numerically stable due to an
implicit regularization of the hedging problem.
The book develops the static super-replication approach in several steps. Chapter 1
summarizes the theoretical tools needed throughout the book, including results from
viii Preface

the fields of mathematical finance and optimization. Afterwards we introduce the con-
cept of statically hedging barrier options in Chapter 2 and review the main approaches
that have been considered in the literature so far.
Chapter 3 presents the starting point of our analysis in the form of a stochastic
optimization problem characterizing cost-optimal static super-replication strategies in
general financial market models. As it turns out, the structure of the problem allows
to prove the existence of optimal static hedging strategies based on suitable results
from the field of convex analysis. In addition we introduce a first naive Monte Carlo
discretization of the stochastic super-replication constraint which allows to compute
the strategy by solving a large scale linear programming problem. Numerical results
for the Black–Scholes and Heston’s stochastic volatility model show that the proposed
approach outperforms all other approaches in the literature. In particular the computed
portfolio matches the sensitivities of the target option and is only marginally more
expensive than the barrier option itself.
Although these results are promising, the Monte Carlo method has the significant
drawback of slow convergence which can lead to long computation times. To circum-
vent this problem, Chapter 4 reformulates the stochastic super-replication constraint
into an infinite number of deterministic constraints. The structure of the resulting lin-
ear semi-infinite optimization problem can be exploited to drastically reduce compu-
tation time in comparison to the Monte Carlo-based method. Moreover, the equivalent
formulation allows to derive the dual optimization problem with an interesting eco-
nomical interpretation. In analogy to the case of dynamic hedging the dual problem
maximizes the discounted expectation of the barrier option payoff. But this time the
expectation is maximized over the set of measures which are price-consistent with re-
spect to the standard options in the hedge portfolio – a far bigger set than the equivalent
martingale measures. This also theoretically underlines that the ability to approximate
call prices is a key property for the derivation of a successful static hedge.
Based on the semi-infinite reformulation of the hedging problem Chapter 5 intro-
duces a robustification of the hedging strategy against changes of the volatility surface.
From an optimization point of view, the robustness is described by model parameter
uncertainty sets which correspond to an infinite number of future volatility surface sce-
narios. The existence of solutions of this problem is proven by applying the maximum
principle and Mizohata’s uniqueness theorem for parabolic partial differential equa-
tions. Furthermore, we prove the convergence of suitable algorithms for the numerical
solution of the robust hedging problem. These methods for the first time quantify and
eliminate the model parameter sensitivity of hedge portfolios for barrier options by
addressing the nonlinearity of call option prices with respect to changes of the volatil-
ity surface. Numerical results for the Black–Scholes and Heston’s stochastic volatility
model show that robustness against model parameter uncertainty can be gained by
surprisingly low cost.
Chapter 6 shows that the previous results can in analogy be transfered to a sub-
replication setting. Combined with the super-replication prices this leads to robust
Preface ix

static bounds for the price of barrier options which are surprisingly tight if compared
to purely model-independent bounds in the literature. Moreover, we also robustify the
static hedging problem against jumps by introducing an additional model parameter
uncertainty set. However, based on the maximum principle, we can eliminate this
uncertainty set and transform the problem to a formulation which can be interpreted as
moving the barrier. The chapter concludes with a section which shows how to apply
the robust hedging approach to a large variety of barrier option contracts.
Chapter 7 considers an additional robustification against model errors in the form
of ellipsoidal uncertainty sets in the price space. Fortunately, these ellipsoidal uncer-
tainty sets can be replaced by an infinite number of second order cone or semidefinite
programming constraints. To compute a solution of the problem, we propose an algo-
rithm successively solving linear and nonlinear semidefinite programming problems
and prove its convergence under mild conditions.
Finally, Chapter 8 analyzes the real world performance of the static superhedge
based on a seven year dataset. As it turns out, the theoretical robustness against
changes of the volatility surface (including the skew) is also confirmed empirically.
Compared to a static strike spread hedge and a dynamic local volatility hedge, the
robust static superhedge is the portfolio leading to the smallest hedge error dispersion.
To summarize, the book develops a static hedging approach which allows to ro-
bustify trading strategies against model parameter uncertainty in the form of volatility
shocks, skew and jump risk as well as model errors. The practical applicability of
the framework as well as the performance of the trading strategies are illustrated with
numerous examples throughout the book.

Some Words of Gratitude

This book is based on the author’s dissertation accepted on March 5th, 2007, at the
University of Trier. Most of the work evolved during my time as a research associate
at the Department of Mathematics, in the research group Numerical Analysis led by
Prof. Dr. Ekkehard W. Sachs. At this point I would like to thank the people who have
contributed to this research and supported me during the past years.
First of all I would like to thank my advisor Prof. Dr. Ekkehard W. Sachs for numer-
ous discussions as well as the joint work and publications on static hedging. Besides
his contributions to this work, I am especially grateful that he encouraged me to ex-
perience all aspects of the life of a researcher including the freedom to choose my
academic focus, the opportunity to participate in various international conferences and
that he always supported my ambitions to work on projects with external industry
partners. It was a very inspiring and pleasant time in the research group.
Furthermore, I wish to thank Dr. Hansjörg Albrecher for fruitful comments and for
acting as a referee of my PhD thesis.
In addition I would like to thank the Financial Engineering team (Equities, Com-
modities and Funds) of UniCredit Markets & Investment Banking, Bayerische Hypo-
x Preface

und Vereinsbank AG, for supporting and initiating my work on static hedging during a
joint research project. I am particularly indebted to Alexander Giese for very deep and
enduring discussions on this work and the practice of mathematical finance in general.
Our initial paper on static hedging was the starting point for the research presented in
this book.
Moreover, I wish to express my gratitude to Dr. Friedemann Leibfritz for detailed
discussions on the theory and practice of optimization as well as the joint work on
the robustification against model errors. My thanks also go to Morten Nalholm and
Matthias Fengler for the collaboration regarding the empirical performance of the
robust static hedge. I also thank my colleagues Ewgenij Hübner, Ilia Gherman and
Christina Jager at the University of Trier for a great time in the department of mathe-
matics.
Special thanks go to PD Dr. Robert Plato for numerous suggestions and for being so
patient with respect to necessary revisions of the manuscript. Moreover, I am grateful
for the detailed comments and suggestions of an anonymous referee.
Finally, I would like to thank my wife Sylvia for constantly supporting me over the
past years. Without her the completion of this research would not have been possible.
I am also indebted to my parents for their moral and financial support of my academic
career.

Jan Maruhn
Munich, April 2009
Contents

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii

1 Theoretical Background . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Probability Theory and Stochastic Differential Equations . . . . . . . 1
1.2 Fundamentals of Mathematical Finance . . . . . . . . . . . . . . . . 4
1.3 Optimization Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

2 Static Hedging of Barrier Options . . . . . . . . . . . . . . . . . . . . . 15

2.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.2 Semi-Static Hedging Strategies . . . . . . . . . . . . . . . . . . . . . 16
2.3 Review of the Static Hedging Literature . . . . . . . . . . . . . . . . 18
2.3.1 Strike Spread Hedge . . . . . . . . . . . . . . . . . . . . . . 18
2.3.2 Calendar Spread Hedge and Extensions . . . . . . . . . . . . 20
2.3.3 The Static Mean Square Hedge . . . . . . . . . . . . . . . . . 23
2.3.4 Model-Independent Super-Hedges . . . . . . . . . . . . . . . 24
2.4 Towards a Practical Static Superhedge . . . . . . . . . . . . . . . . . 26

3 An Optimization Approach to Static Super-Replication . . . . . . . . . 32

3.1 Cost-Optimal Static Super-Replication . . . . . . . . . . . . . . . . . 32
3.2 Numerical Implementation . . . . . . . . . . . . . . . . . . . . . . . 35
3.3 Results and Comparison to other Hedging Approaches . . . . . . . . 38
3.3.1 Static Hedging in the Black–Scholes Model . . . . . . . . . . 38
3.3.2 Static Hedging in Heston’s Stochastic Volatility Model . . . . 43

4 Reformulation as a Semi-Infinite Problem . . . . . . . . . . . . . . . . 50

4.1 Semi-infinite Equivalence . . . . . . . . . . . . . . . . . . . . . . . . 50
4.2 The Dual Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

5 Eliminating Model Parameter Uncertainty . . . . . . . . . . . . . . . . 70

5.1 Robust Static Hedging in the Black–Scholes Model . . . . . . . . . . 72
5.1.1 Description of the Robust Problem . . . . . . . . . . . . . . . 72
5.1.2 Numerical Solution . . . . . . . . . . . . . . . . . . . . . . . 75
5.1.3 An Example of a Hedge Portfolio . . . . . . . . . . . . . . . 78
5.2 Robust Static Hedging in Stochastic Volatility Models . . . . . . . . . 85
5.2.1 Definition of the Robust Problem . . . . . . . . . . . . . . . 86
5.2.2 Solving the Problem . . . . . . . . . . . . . . . . . . . . . . 90
5.2.3 A Detailed Example . . . . . . . . . . . . . . . . . . . . . . 93
xii Contents

6 Modifications and Extensions . . . . . . . . . . . . . . . . . . . . . . . 103

6.1 Sub-Replication and Robust Static Bounds . . . . . . . . . . . . . . . 103
6.2 Robustification against Jumps . . . . . . . . . . . . . . . . . . . . . 107
6.3 Extension to other Barrier Options . . . . . . . . . . . . . . . . . . . 115

7 Avoiding Model Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

7.1 Robustification and Numerical Solution . . . . . . . . . . . . . . . . 124
7.2 Equivalent SDP–NSDP Formulation . . . . . . . . . . . . . . . . . . 130
7.3 Numerical Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

8 Empirical Hedge Performance . . . . . . . . . . . . . . . . . . . . . . . 144

8.1 Description of the Dataset . . . . . . . . . . . . . . . . . . . . . . . 145
8.2 Setting up the Robust Static Hedge . . . . . . . . . . . . . . . . . . . 148
8.2.1 Step-Wise Robustification . . . . . . . . . . . . . . . . . . . 149
8.2.2 Sensitivity Analysis With Respect to Initial Cost . . . . . . . 152
8.3 Other Hedging Approaches Used in the Study . . . . . . . . . . . . . 154
8.4 Experimental Design . . . . . . . . . . . . . . . . . . . . . . . . . . 155
8.5 Empirical Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

9 Summary and Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

A General Existence Theorem . . . . . . . . . . . . . . . . . . . . . . . . 167

B Source Code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

List of Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

List of Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

List of Algorithms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

List of Code Listings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

Symbols and Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . 192

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
1 Theoretical Background
In this chapter we review some basic mathematical concepts which we refer to through-
out the book. Section 1.1 briefly introduces some definitions from probability theory
and the field of stochastic differential equations. Afterwards Section 1.2 presents the
main ideas of mathematical finance which are relevant in our context. In Section 1.3
we finally discuss several classes of optimization problems with a particular focus on
the definition and properties of linear semi-infinite programming problems.

1.1 Probability Theory and Stochastic Differential Equations

The concepts we introduce in this section briefly summarize the main probabilistic
definitions we need during the remainder of this work. A more detailed discussion of
the presented topics can be found in Bauer [7] and Shiryaev [81].
As a starting point we assume the existence of a probability space .; F ; P /, where
F denotes a sigma-algebra over the set  ¤ ; and P is a suitable probability measure.
In this context a set N 2 F is a null set if and only if P .N / D 0. A property, defined
for all ! 2 , is said to hold almost surely (a.s.) if there exists a null-set N such
that the property holds for all ! 2 N c . Examples in our setting include inequalities or
equalities of real-valued random variables X; Y W  ! R to hold almost surely, e.g.
X  Y (a.s.) or X D Y (a.s.).
If B 2 F is a given set, the measure P restricted to B is defined by P jB .
/ WD
P .
\ B/=P .B/. Furthermore, the measure P .X;Y / denotes the joint distribution of
two random variables X and Y under P . In case .; F / D .R; B/, where B is the
Borel sigma algebra, supp.P / denotes the support of P , that is the smallest closed set
with measure 1.
For I  RC the family F D .F t / t2I is called a filtration on the measurable space
.; F / if F t  F 8 t and Fs  F t for s; t 2 I , s < t . If we further denote the
set of all null sets by N , i.e. N D ¹N 2 F W P .N / D 0º, then the augmented
filtration F D .F t / t2I of F D .F t / t2I is the family of smallest sigma-algebras F t
containing F t [ N .
Given a filtration F D .F t / t2I , a random variable  W  ! I [ ¹sup I º is called
F-stopping time if ¹! 2  W  .!/  t º 2 F t for all t 2 I .
A family of random variables X D .X t / t2I , X t W  ! Rm defines a stochastic
process on .; F ; P /. For fixed ! 2  the mapping t 7! X t .!/ describes a path
of the process .X t / t2I . The process X is said to be adapted to the filtration F if X t
is F t -measurable for all t . X is F-progressively measurable if I D Œ0; T  and the
mapping Œ0; t    ! R, .s; !/ 7! Xs .!/ is measurable with respect to the product
sigma-algebra B ˝ F t 8 t  0. Furthermore, we define the filtration FX D .F tX / t2I
2 Chapter 1 Theoretical Background

generated by X as the family of smallest sigma-algebras F tX such that Xs is F tX -

measurable for all s  t . The probably most well-known example of a stochastic
process is implicitly defined via the following axioms.

Definition 1.1. Let .; F ; P / be a probability space with filtration F D .F t / t2I ,

I D Œ0; T , 0 < T < 1, or I D RC . Then a stochastic process W D .W t / t2I ,
W t W  ! R, is called an F-Wiener process (or F-Brownian motion) if
i) W0 D 0 (a.s.)
ii) W t Ws is independent from Fs for all s; t 2 I , 0  s < t
iii) P W t Ws is normally distributed with mean zero and variance t s for all 0 
s < t with s; t 2 I
iv) The mapping t 7! W t .!/ is continuous (a.s.).
Furthermore, a process W D .W t1 ; : : : ; W tm / t2I , W ti W  ! R, i D 1; : : : ; m, is
called a multidimensional F-Wiener process with correlation matrix ƒ D .ij /i;j 2
Rmm if and only if W i is an F-Wiener process for each i and the correlation of W ti
and W tj is ij .

Note that for the special case of a two-dimensional F-Brownian motion W D

.W 1 ; W 2 / the correlation matrix ƒ is uniquely identified by 1;2 D 2;1 DW . Hence,
in this particular situation, the two Brownian motions W 1 ; W 2 are said to be correlated
with correlation coefficient .
Besides the Brownian motions, the martingales form another class of stochastic
processes which play an important role in the theory of mathematical finance.

Definition 1.2. Let X D .X t / t2I , I  RC , be a real-valued stochastic process

adapted to the filtration F with X t 2 L1 .P / 8 t 2 I . Then X is called an .F; P /-
martingale if and only if

E.X t jFs / D Xs .a:s:/ 8 s; t 2 I; s < t:

Further X is a local martingale if there exists a sequence of stopping times .k /k2N ,
k  kC1 , k !k!1 1 (a.s.) 8 k, such that X k D .Xk ^t / t is a martingale 8 k.

Here L1 .P / is the space of measurable, real-valued functions whose absolute value

has a finite integral with respect to P . Further E.X t jFs / denotes the conditional
expectation of X t relative to Fs .
Without presenting the details we mention at this point that stochastic Itô-integrals
are one example for local martingales. Based on this observation, the idea arises to
define a stochastic process which is decomposed in a deterministic drift part and a
martingale part. This idea is formalized in the following definition.
Section 1.1 Probability Theory and Stochastic Differential Equations 3

Definition 1.3. Suppose .; F ; P / is a probability space with filtration F D .F t / t0

and W D .W t / t0 is an F-Brownian motion. Then an Itô process .X t / t0 is a process
of the form
Z t Z t
X t D X0 C Hs ds C K s d Ws ; (1.1)
0 0

where X0 is F0 measurable, K and H are F-progressively measurable and

Z t Z t
jHs jds < 1 8 t .a:s:/; Ks2 ds < 1 8 t .a:s:/: (1.2)
0 0
Rt
In (1.1) the term 0 Ks d Ws denotes the stochastic integral of K with respect to
Rthe
t
Brownian motion W . The conditions (1.2) guarantee that this integral as well as
0 Hs ds are well defined.
Equipped with this notation, we can move on to the concept of stochastic differential
equations. Instead of defining a stochastic process explicitly as we did in Definition
1.3, we now wish to define a process by its initial value and its dynamics over time.

Definition 1.4. Assume that a probability space .; F ; P / with augmented filtration
F D .F t / t2I , I D Œ0; T  is given. Further let W D .W t1 ; : : : ; W tk / t2I be an F-
Brownian motion and assume that ˇ D .ˇ1 ; : : : ; ˇm / W RC  Rm ! Rm , D
. ij /i;j W RC  Rm ! Rmk are Borel-measurable functions. Suppose that  D
.1 ; : : : ; m / is an Rm -valued, F0 -measurable random variable. Then an Rm -valued
process X D .X t1 ; : : : ; X tm / t2I is a solution of the system of stochastic differential
equations
k
X j
dX ti D ˇi .t; X t /dt C ij .t; X t /d W t ; X0i D i ; 1  i  m (1.3)
j D1

Rt Rt j
with initial condition X0 D , if the integrals 0 ˇi .s; Xs /ds, 0 ij .s; Xs /d Ws are
well defined for all t and
Z t k Z
X t
X ti D i C ˇi .s; Xs /ds C ij .s; Xs /d Ws
j
.a:s:/ 8 t 2 I; 1  i  m:
0 j D1 0

For a more detailed introduction to the theory of stochastic differential equations

we refer the reader to the books of Øksendal [75] or Karatzas and Shreve [57]. In
both books the authors further prove variants of the following existence result for the
solution of stochastic differential equations.

Theorem 1.5. Based on the notation and assumptions of Definition 1.4 we further
suppose that kk2 is square integrable and that the following conditions hold:
4 Chapter 1 Theoretical Background

i) Lipschitz condition: 8 T > 0 8 N > 0 9 c1 .T; N / < 1 such that 8 t 2 Œ0; T ,

8 x; y 2 Rm satisfying kxk2 ; kyk2  N we have

kˇ.t; x/ ˇ.t; y/k2 C jk .t; x/ .t; y/kj2  c1 .T; N /kx yk2

ii) Growth-condition: 8 T > 0 9 c2 .T / < 1 such that 8 t 2 Œ0; T , 8 x 2 Rm

kˇ.t; x/k22 C jk .t; x/kj22  c2 .T /.1 C kxk22 /:

Then the stochastic differential equation (1.3) has an almost surely unique solution.

Proof. See Øksendal [75], Theorem 5.2.1 and the weakening of the Lipschitz condi-
tion in Irle [54], Theorem 13.9. 

Within this work we are mostly concerned with the case of m D k D 1 and
m D k D 2, that is either we have a one-dimensional stochastic differential equation
driven by one Brownian motion or a system of two equations driven by two Brownian
motions.
In either case, an analytic solution of the equations might not be possible such that
we have to approximate the solution numerically. For this purpose a variety of dis-
cretization schemes are available (see for example Kloeden and Platen [59] or Kloeden,
Platen and Schurz [60]). In our context the Euler–Maruyama scheme is of sufficient
accuracy. Given a stochastic differential equation (1.3), the scheme approximates the
process X on a time grid 0 D t0 < t1 < : : : < tN D T by setting X t0 D  and then
proceeding for  D 1; : : : ; N via the recursion

X ti D X ti 1
C ˇi .t 1 ; X t 1 /.t t 1 /C
k
X j j
(1.4)
C ij .t 1 ; X t 1 /.W t W t 1 / 8 i D 1; : : : ; m:
j D1

Coupled with a Monte Carlo discretization of appropriate expectation functionals, the

Euler–Maruyama scheme will be used for the approximation of stochastic optimiza-
tion problems as well as the simulation of hedge error distributions in financial market
applications. In the next section we establish the basis for these applications by intro-
ducing some fundamental concepts of mathematical finance.

1.2 Fundamentals of Mathematical Finance

Based on the notion of stochastic differential equations we are now able to define
the dynamics of financial market models and to introduce several basic concepts of
mathematical finance. Note that a more detailed discussion of the presented topics can
be found in Elliott and Kopp [31] or Karatzas and Shreve [58]. In the following we
consider a general financial market model as defined below.
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