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A solution approach to valuation with unhedgeable risks

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  • Thaleia Zariphopoulou

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    (School of Business and Department of Mathematics, University of Wisconsin Madison, WI 53706, USA Manuscript)

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    Abstract

    We study a class of stochastic optimization models of expected utility in markets with stochastically changing investment opportunities. The prices of the primitive assets are modelled as diffusion processes whose coefficients evolve according to correlated diffusion factors. Under certain assumptions on the individual preferences, we are able to produce reduced form solutions. Employing a power transformation, we express the value function in terms of the solution of a linear parabolic equation, with the power exponent depending only on the coefficients of correlation and risk aversion. This reduction facilitates considerably the study of the value function and the characterization of the optimal hedging demand. The new results demonstrate an interesting connection with valuation techniques using stochastic differential utilities and also, with distorted measures in a dynamic setting.

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    Bibliographic Info

    Article provided by Springer in its journal Finance and Stochastics.

    Volume (Year): 5 (2001)
    Issue (Month): 1 ()
    Pages: 61-82

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    Handle: RePEc:spr:finsto:v:5:y:2001:i:1:p:61-82

    Note: received: January 1999; final version received: February 2000
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    Related research

    Keywords: Non-traded assets; stochastic factors; unhedgeable risks; portfolio management; reduced form solutions;

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