On the hedging problem in general 1D diffusion markets

Source abstract

We develop a PDE-based methodology for pricing and hedging European contingent claims in general one-dimensional diffusion markets characterized solely by their scale function and speed measure, possibly without a classical SDE representation, and with constant interest rate. We derive a hedging equation whose solution generates a self-financing hedging strategy and provide sufficient conditions on scale, speed, and interest rate, under which this strategy achieves the minimal hedging capital, expressed through the no free lunch with vanishing risk (NFLVR) condition. We further prove necessary and sufficient conditions for NFLVR and characterize the class of equivalent local martingale measures through an auxiliary diffusion whose scale and speed characteristics are determined by those of the real-world diffusion and by the interest rate. When the NFLVR condition fails, the framework may produce multiple hedging equations corresponding to non-minimal strategies, whose associated prices can exceed the minimal hedging capital. We illustrate both the effectiveness and limitations of the approach through numerical experiments involving diffusion models with irregular features.