PHILOSOPHY in pricing derivatives

(posts from old site)

1. Specify a model under the Q(theta)-dynamics
• theta is a vector of parameters, e.g. volatility, drift, etc.
• Q() is the risk neutral framework
2. Price all securities at time t by discounting the next period (t+1) risk neutral prices
3. Calibrate the model by choosing theta so that market prices of appropriate liquid securities agree with model prices of those securities
• this calibration procedure to market prices will incorporate the factors not specified in the model, e.g. policy risk, market expectation, economic outlook, etc.