Pricing Options in Incomplete Equity Markets via the Instantaneous Sharpe Ratio
Loading...
Date
Authors
Journal Title
Journal ISSN
Volume Title
Publisher
Abstract
Description
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 Saá-Requejo (2000) and of Björk 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).
Keywords: Pricing derivative securities, incomplete markets, Sharpe ratio, correlated assets, stochastic volatility, non-linear partial differential equations, good deal bounds
Keywords: Pricing derivative securities, incomplete markets, Sharpe ratio, correlated assets, stochastic volatility, non-linear partial differential equations, good deal bounds