This would be relevant when we are pricing a derivative security
on a stock by forming a portfolio between the underlying stock and a risk-free bond, which dynamically replicates the payoffs of the derivative security
Second, the author could include more discussion of how each American-style derivative security
described in the book can be used to manage risk and/or increase investment returns.
1) The theoretical pricing model is inadequate or inaccurate, which implies that the observed market price may very well be the true price of the derivative security
A derivative security
has contractually determined payouts that can be described by functions of observable asset prices and time.
The derivative security
is valued based on these asset prices by recursively working back through the model from the derivative's final maturity.
On the trading floor, analysts are studying a complex derivative security
the bank owns by testing its behavior under thousands of possible market scenarios.
They show that granularity is a function of the contract specifications of the derivative security
and of the degree of market completeness.