HEDGING UNDER ARBITRAGE

It is shown that delta hedging provides the optimal trading strategy in terms of minimal required initial capital to replicate a given terminal payoff in a continuous‐time Markovian context. This holds true in market models in which no equivalent local martingale measure exists but only a square‐integrable market price of risk. A new probability measure is constructed, which takes the place of an equivalent local martingale measure. To ensure the existence of the delta hedge, sufficient conditions are derived for the necessary differentiability of expectations indexed over the initial market configuration. The phenomenon of “bubbles,” which has recently been frequently discussed in the academic literature, is a special case of the setting in this paper. Several examples at the end illustrate the techniques described in this work.