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Growth optimal investment and pricing of derivatives

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  • Aurell, Erik
  • Baviera, Roberto
  • Hammarlid, Ola
  • Serva, Maurizio
  • Vulpiani, Angelo

Abstract

We introduce a criterion how to price derivatives in incomplete markets, based on the theory of growth optimal strategy in repeated multiplicative games. We present reasons why these growth-optimal strategies should be particularly relevant to the problem of pricing derivatives. Under the assumptions of no trading costs, and no restrictions on lending, we find an appropriate equivalent martingale measure that prices the underlying and the derivative security. We compare our result with other alternative pricing procedures in the literature, and discuss the limits of validity of the lognormal approximation. We also generalize the pricing method to a market with correlated stocks. The expected estimation error of the optimal investment fraction is derived in a closed form, and its validity is checked with a small-scale empirical test.

Suggested Citation

  • Aurell, Erik & Baviera, Roberto & Hammarlid, Ola & Serva, Maurizio & Vulpiani, Angelo, 2000. "Growth optimal investment and pricing of derivatives," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 280(3), pages 505-521.
    • Handle: RePEc:eee:phsmap:v:280:y:2000:i:3:p:505-521
    DOI: 10.1016/S0378-4371(00)00005-4
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    References listed on IDEAS

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    Cited by:

    1. Andrew W. Lo & H. Allen Orr & Ruixun Zhang, 2018. "The growth of relative wealth and the Kelly criterion," Journal of Bioeconomics, Springer, vol. 20(1), pages 49-67, April.

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