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Indifference Pricing of American Option Underlying Illiquid Stock under Exponential Forward Performance

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  • Xiaoshan Chen
  • Qingshuo Song
  • Fahuai Yi
  • George Yin
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    Abstract

    This work focuses on the indifference pricing of American call option underlying a non-traded stock, which may be partially hedgeable by another traded stock. Under the exponential forward measure, the indifference price is formulated as a stochastic singular control problem. The value function is characterized as the unique solution of a partial differential equation in a Sobolev space. Together with some regularities and estimates of the value function, the existence of the optimal strategy is also obtained. The applications of the characterization result includes a derivation of a dual representation and the indifference pricing on employee stock option. As a byproduct, a generalized Ito's formula is obtained for functions in a Sobolev space.

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    File URL: http://arxiv.org/pdf/1201.0075
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1201.0075.

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    Date of creation: Dec 2011
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    Handle: RePEc:arx:papers:1201.0075

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    1. Tim Leung & Ronnie Sircar, 2009. "Accounting For Risk Aversion, Vesting, Job Termination Risk And Multiple Exercises In Valuation Of Employee Stock Options," Mathematical Finance, Wiley Blackwell, vol. 19(1), pages 99-128.
    2. A. Oberman & T. Zariphopoulou, 2003. "Pricing early exercise contracts in incomplete markets," Computational Management Science, Springer, vol. 1(1), pages 75-107, December.
    3. M. Musiela & T. Zariphopoulou, 2009. "Portfolio choice under dynamic investment performance criteria," Quantitative Finance, Taylor and Francis Journals, vol. 9(2), pages 161-170.
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