Stochastic integral representations, stochastic derivatives and minimal variance hedging

Abstract

The stochastic integral representation for an arbitrary random variable in a standard L 2 -space is considered in the case of the integrator as a martingale. In relation to this, a certain stochastic derivative is defined. It is shown that this derivative determines the integrand in the stochastic integral which serves as the best L 2 - approximation to the random variable considered. For a general Lévy process as integrator some specification of the suggested stochastic derivative is given. In the case of the Wiener process the considered specification reduces to the well-known Clark-Haussmann-Ocone formula. This result provides a general solution to the problem of minimal variance hedging in incomplete markets.

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