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Model misspecification and pricing of illiquid claims

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  • Rubtsov, Alexey

Abstract

This paper analyses the impact of model misspecification on pricing and hedging of illiquid claims. We consider the case when an ambiguous investor hedges his position in an illiquid claim, written on a nontraded asset, by investing in a tradable asset. The optimal trading strategy and utility indifference price of the claim are derived. It is shown that when the model for the underlying asset is misspecified, the utility indifference price is not necessarily increasing or decreasing in the correlation between traded and nontraded assets. An explanation for the puzzle of why small retail investors buy structured bonds is given.

Suggested Citation

  • Rubtsov, Alexey, 2016. "Model misspecification and pricing of illiquid claims," Finance Research Letters, Elsevier, vol. 18(C), pages 242-249.
    • Handle: RePEc:eee:finlet:v:18:y:2016:i:c:p:242-249
    DOI: 10.1016/j.frl.2016.04.023
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    Cited by:

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    2. Rubtsov, Alexey & Xu, Wei & Šević, Aleksandar & Šević, Željko, 2021. "Price of climate risk hedging under uncertainty," Technological Forecasting and Social Change, Elsevier, vol. 165(C).

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    More about this item

    Keywords

    Robust portfolio choice; Pricing illiquid claims; Nontraded assets;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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