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Beyond Arbitrage: "Good-Deal" Asset Price Bounds in Incomplete Markets

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  • John H. Cochrane
  • Jesus Saa-Requejo

Abstract

It is often useful to price assets and other random payoffs by reference to other observed prices rather than construct full-fledged economic asset pricing models. This approach breaks down if one cannot find a perfect replicating portfolio. We impose weak economic restrictions to derive usefully tight bounds on asset prices in this situation. The bounds basically rule out high Sharpe ratios - `good deals' - as well as arbitrage opportunities. We present the method of calculation, we extend it to a multiperiod context by finding a recursive solution, and we apply it to option pricing examples including the Black-Scholes setup with infrequent trading, and a model with stochastic stock volatility and a varying riskfree rate.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5489.

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Date of creation: Mar 1996
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Publication status: published as Journal of Political Economy (February 2000 Revision of W5489, March 1996)
Handle: RePEc:nbr:nberwo:5489

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Cited by:
  1. Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2009. "Demand-Based Option Pricing," Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 4259-4299, October.
  2. Morten Christensen & Eckhard Platen, 2005. "Sharpe Ratio Maximization and Expected Utility when Asset Prices have Jumps," Research Paper Series 170, Quantitative Finance Research Centre, University of Technology, Sydney.
  3. David S. Bates, 1999. "Financial Markets' Assessment of EMU," NBER Working Papers 6874, National Bureau of Economic Research, Inc.
  4. HENROTTE, Philippe, 2002. "Pricing kernels and dynamic portfolios," Les Cahiers de Recherche 768, HEC Paris.
  5. Kerkhof, F.L.J. & Melenberg, B. & Schumacher, J.M., 2002. "Model Risk and Regulatory Capital," Discussion Paper 2002-27, Tilburg University, Center for Economic Research.
  6. Matos, Joao Amaro de & Lacerda, Ana, 2006. "Dry Markets and Statistical Arbitrage Bounds for European Derivatives," FEUNL Working Paper Series wp479, Universidade Nova de Lisboa, Faculdade de Economia.
  7. Carmona, Julio & León, Ángel & Vaello-Sebastià, Antoni, 2012. "Executive Stock Options and Time Diversification," QM&ET Working Papers 12-16, Universidad de Alicante, Departamento de Métodos Cuantitativos y Teoría Económica.
  8. L. Carassus & E. Temam, 2014. "Pricing and hedging basis risk under no good deal assumption," Annals of Finance, Springer, vol. 10(1), pages 127-170, February.
  9. Björk, Tomas & Slinko, Irina, 2004. "Towards a General Theory of Good Deal Bounds," Working Paper Series in Economics and Finance 595, Stockholm School of Economics.
  10. Jan Voelzke, 2014. "Weakening the Gain-Loss-Ratio measure to make it stronger," CQE Working Papers 3114, Center for Quantitative Economics (CQE), University of Muenster.
  11. Pierluigi Balduzzi & Cesare Robotti, 2001. "Minimum-variance kernels, economic risk premia, and tests of multi-beta models," Working Paper 2001-24, Federal Reserve Bank of Atlanta.
  12. Peter Ryan, 2000. "Tighter Option Bounds from Multiple Exercise Prices," Review of Derivatives Research, Springer, vol. 4(2), pages 155-188, May.
  13. Ángel León Valle & Antonio Vaello & Julio Carmona, 2009. "Pricing executive stock options under employment shocks," Working Papers. Serie AD 2009-22, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  14. Matos, Joao Amaro de & Lacerda, Ana, 2004. "Dry Markets and Superreplication Bounds of American Derivatives," FEUNL Working Paper Series wp461, Universidade Nova de Lisboa, Faculdade de Economia.
  15. Alfredo Ibáñez, 2005. "Option-Pricing in Incomplete Markets: The Hedging Portfolio plus a Risk Premium-Based Recursive Approach," Computing in Economics and Finance 2005 216, Society for Computational Economics.
  16. João Amaro de Matos & Paula Antão, 2001. "Super-replicating Bounds on European Option Prices when the Underlying Asset is Illiquid," Economics Bulletin, AccessEcon, vol. 7(1), pages 1-7.
  17. Sara Biagini & Mustafa Pinar, 2012. "The best gain-loss ratio is a poor performance measure," Papers 1209.6439, arXiv.org, revised Dec 2012.

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