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Principles of Financial Engineering, 3rd Edition by Salih N. Neftci, Robert Kosowski

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Chapter 8

Dynamic Replication Methods and Synthetics Engineering

This chapter explains the differences between static and dynamic replication. It reviews static replication in the context of bond immunization. We then introduce dynamic hedging in the context of hedging bond positions before moving on to dynamic replication of options using binomial trees. We highlight the distinction between dynamic replication in continuous and discrete time and discuss real-life complications such as bid–ask spreads, jumps, maintenance and operation costs as well as changes in volatility.

Keywords

binomial trees; dynamic replication; immunization; jumps; liquidity; static replication; time-varying volatility

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