Mathematics – Optimization and Control
Scientific paper
2007-01-23
Mathematics
Optimization and Control
Keywords: Pricing derivative securities, incomplete markets, Sharpe ratio, correlated assets, stochastic volatility, non-linea
Scientific paper
We use a continuous version of the standard deviation premium principle for pricing in incomplete equity markets by assuming that the investor issuing an unhedgeable derivative security requires compensation for this risk in the form of a pre-specified instantaneous Sharpe ratio. First, we apply our method to price options on non-traded assets for which there is a traded asset that is correlated to the non-traded asset. Our main contribution to this particular problem is to show that our seller/buyer prices are the upper/lower good deal bounds of Cochrane and Sa\'{a}-Requejo (2000) and of Bj\"{o}rk and Slinko (2006) and to determine the analytical properties of these prices. Second, we apply our method to price options in the presence of stochastic volatility. Our main contribution to this problem is to show that the instantaneous Sharpe ratio, an integral ingredient in our methodology, is the negative of the market price of volatility risk, as defined in Fouque, Papanicolaou, and Sircar (2000).
Bayraktar Erhan
Young Virginia R.
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