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Contingent claim pricing using probability distortion operators: methods from insurance risk pricing and their relationship to financial theory

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  • Mahmoud Hamada
  • Michael Sherris
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    Abstract

    This paper considers the pricing of contingent claims using an approach developed and used in insurance pricing. The approach is of interest and significance because of the increased integration of insurance and financial markets and also because insurance-related risks are trading in financial markets as a result of securitization and new contracts on futures exchanges. This approach uses probability distortion functions as the dual of the utility functions used in financial theory. The pricing formula is the same as the Black-Scholes formula for contingent claims when the underlying asset price is log-normal. The paper compares the probability distortion function approach with that based on financial theory. The theory underlying the approaches is set out and limitations on the use of the insurance-based approach are illustrated. The probability distortion approach is extended to the pricing of contingent claims for more general assumptions than those used for Black-Scholes option pricing.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/1350486032000069580
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Applied Mathematical Finance.

    Volume (Year): 10 (2003)
    Issue (Month): 1 ()
    Pages: 19-47

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    Handle: RePEc:taf:apmtfi:v:10:y:2003:i:1:p:19-47

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    Web page: http://www.tandfonline.com/RAMF20

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    Related research

    Keywords: Contingent Claim Pricing; Probability Distortion Functions; Non-expected Utility; Insurance Pricing; Black And Sholes;

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    Cited by:
    1. Balbás, Alejandro & Balbás, Beatriz & Balbás, Raquel, 2010. "CAPM and APT-like models with risk measures," Journal of Banking & Finance, Elsevier, vol. 34(6), pages 1166-1174, June.
    2. Mahmoud Hamada & E. Valdez, 2004. "CAPM and Option Pricing with Elliptical Disbributions," Research Paper Series 120, Quantitative Finance Research Centre, University of Technology, Sydney.
    3. Hammoudeh, Shawkat & McAleer, Michael, 2013. "Risk management and financial derivatives: An overview," The North American Journal of Economics and Finance, Elsevier, vol. 25(C), pages 109-115.
    4. Corradini, M. & Gheno, A., 2009. "Incomplete financial markets and contingent claim pricing in a dual expected utility theory framework," Insurance: Mathematics and Economics, Elsevier, vol. 45(2), pages 180-187, October.
    5. Massimiliano Corradini & Andrea Gheno, 2007. "Contingent Claim Pricing In A Dual Expected Utility Theory Framework," Departmental Working Papers of Economics - University 'Roma Tre' 0082, Department of Economics - University Roma Tre.

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