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Real-world options: smile and residual risk

Abstract

We present a theory of option pricing and hedging, designed to address non-perfect arbitrage, market friction and the presence of `fat' tails. An implied volatility `smile' is predicted. We give precise estimates of the residual risk associated with optimal (but imperfect) hedging.Comment: 11 pages,Latex, 5 figures (appended as uuencoded compressed tar -file

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