Pricing and Hedging Basis Risk under No Good Deal Assumption
AbstractWe consider the problem of pricing and hedging an option written on a non-exchangeable asset when trading in a correlated asset is possible. This is a typical case of incomplete market where it is well known that the super-replication concept provides generally too high prices. Here, following J.H. Cochrane and J. Saá-Requejo, we study valuation under No Good Deal (NGD) Assumption. First, we clarify the notion of NGD for dynamic strategies, compute a lower and an upper bound and prove that in fact NGD price can be strictly higher that the one previously compute in the literature. We also propose a hedging strategy by imposing criterium on the variance of the replication's error. Finally, we provide various numerical illustrations showing the efficiency of NGD pricing and hedging.
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Date of creation: 07 Jul 2010
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No Good Deal; basis risk; mean variance hedging;
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- Björk, Tomas & di Masi, Giovanni & Kabanov, Yuri & Runggaldier, Wolfgang, 1996.
"Towards a General Theory of Bond Markets,"
Working Paper Series in Economics and Finance
143, Stockholm School of Economics.
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