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Martingale Pricing

Author

Listed:
  • Kerry Back

    (Jones Graduate School of Business, Rice University, Houston, Texas 77005)

Abstract

The fact that properly normalized asset prices are martingales is the basis of modern asset pricing. One normalizes asset prices to adjust for risk and time preferences. Both adjustments can be made simultaneously via a stochastic discount factor, or one can adjust for risk by changing probabilities and adjust for time using the return on an asset, for example, the risk-free return. This paper reviews this methodology and the circumstances in which it is feasible. Three examples are given to illustrate the delicate link in continuous-time models between the absence of arbitrage opportunities and the feasibility of martingale pricing.

Suggested Citation

  • Kerry Back, 2010. "Martingale Pricing," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 235-250, December.
    • Handle: RePEc:anr:refeco:v:2:y:2010:p:235-250
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    File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-073009-104041
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    Citations

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    Cited by:

    1. Nikolai Dokuchaev, 2011. "On martingale measures and pricing for continuous bond-stock market with stochastic bond," Papers 1108.0719, arXiv.org, revised Sep 2014.
    2. Gabriel Frahm, 2015. "A theoretical foundation of portfolio resampling," Theory and Decision, Springer, vol. 79(1), pages 107-132, July.
    3. Yaroslav Ivanenko & Illya Pasichnichenko, 2013. "Uncertainty and absence of arbitrage opportunity," Papers 1307.5602, arXiv.org.

    More about this item

    Keywords

    arbitrage; risk-neutral probability; equivalent martingale measure; stochastic discount factor; state price density process; change of numeraire;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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