CHAPTER 22

Engineering of Equity Instruments: Pricing and Replication

1. Introduction

Fixed-income instruments involve payoffs that are, in general, known and “fixed.” They also have set maturity dates. Putting aside the credit quality of the instrument, fixed-income assets have relatively simple cash flows that depend on a known, small set of variables and, hence, risk factors. There are also well-established and quite accurate ways to calculate the relevant term structure. Finally, there are several liquid and efficient fixed-income derivatives markets such as swaps, forward rate agreements (FRAs), and futures, which simplify the replication and pricing problems existing in this sector.

There is no such luxury in equity analysis. The underlying ...

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