Perfect Hedging of Index Derivatives under a Minimal Market Model

The paper presents a nancial market model that generates stochastic volatility using a minimal set of factors These factors formed by transformations of square root processes model the dynamics of di erent denominations of a benchmark portfolio Benchmarked prices are assumed to be local martin gales Numerical results for the pricing and hedging of basic derivatives on indices are described for the minimal market model This includes cases where the standard risk neutral pricing methodology fails because of the presence of a strict local martingale measure However payo s can be perfectly hedged using self nancing strategies and a form of arbitrage exists This is illustrated by hedge simulations The di erent term structure of implied volatilities is documented for calls and puts on an index Mathematics Subject Classi cation primary A secondary G P JEL Classi cation G