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Option Pricing & Partial Hedging: Theory Of Polish Options

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Author Info

  • Erik Aurell

    (Artificial Economy Project, PDC/KTH, S-100 44 Stockholm, Sweden)

  • Karol Zyczkowski
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    Abstract

    The twin problems of hedging and pricing of options in discrete-time markets are analyzed. We consider trading strategies consisting of one stock and one bond. The bond price rises deterministically over time while the stock price can change in several (more than two) ways at each instant of trading. Given such stock price movements, perfect hedging is not possible, and arbitrage arguments alone are not sufficient. We deter- mine hedging and bid and ask prices by balancing expected gain against risk. Using a recent approach of Bouchaud and Sornette, we work out in detail the case where the mean rate of return of the stock differs from that of the bond. We identify a new kind of strategy open to operators that are sufficiently insensitive to risk. We find a candidate for market price of risky options, which reduces to the Black- Scholes prescription when risk can be eliminated. We report on data on stock price movements on the Warsaw Stock Exchange, and show that they are well described by a simple model where prices on each day can either increase, decrease or stay the same. We work out the details of the option pricing and hedging problems in this case.

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    File URL: http://128.118.178.162/eps/fin/papers/9601/9601001.pdf
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    Bibliographic Info

    Paper provided by EconWPA in its series Finance with number 9601001.

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    Length: 30 pages
    Date of creation: 13 Jan 1996
    Date of revision:
    Handle: RePEc:wpa:wuwpfi:9601001

    Note: 30 pages, PostScript format 969 kb, uuencoded. Five figures, available separately from K. \.Zyczkowski upon request.
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    Web page: http://128.118.178.162

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    Cited by:
    1. Schweizer, Martin, 2001. "From actuarial to financial valuation principles," Insurance: Mathematics and Economics, Elsevier, vol. 28(1), pages 31-47, February.

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