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perhaps the best-known case. There are, however, many examples, some considerably
simpler.
In cases in which a closed-form formula does not exist, the analyst tries to
obtain an equation that governs the dynamics of F(St ,t)
In this section, we show examples of how to determine such as F(St ,t). The
discussion is intended to introduce new mathematical tools and concepts that have
common use in pricing derivative product.
2.1
Forwards
Consider the class of cash-and-carry goods2. Here we show how a pricing
function F(St ,t), where St is the underlying asset, can be obtained for forward
contracts. In particular, we consider a forward contract with the following provisions:
(1)
Hence, we have a contract that imposes an obligation on both counterpartiesthe one that delivers the gold, and the one that accepts the delivery. How can one
determine a function F(St ,t) that gives the fair market value of such a contract at time
t in term of the underlying parameters? We use an arbitrage argument.
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nonexistence of a pricing function. It may simply mean that we are not able to express the
pricing function in terms of a simple formula. For example, al continuous and smooth
function can be expanded as an infinite Taylor series expansion. At the same time, truncating
Taylor series in Order to obtain a closed-form formula would in general lead to an
approximation error.
2