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Pricing options in incomplete equity markets via the instantaneous Sharpe ratio

  • Erhan Bayraktar

    ()

  • Virginia Young

    ()

We use a continuous version of the standard deviation premium principle for pricing in incomplete equity markets by assuming that the investor issuing an unhedgeable derivative security requires compensation for this risk in the form of a pre-specified instantaneous Sharpe ratio. First, we apply our method to price options on non-traded assets for which there is a traded asset that is correlated to the non-traded asset. Our main contribution to this particular problem is to show that our seller/buyer prices are the upper/lower good deal bounds of Cochrane and Sa\'{a}-Requejo (2000) and of Bj\"{o}rk and Slinko (2006) and to determine the analytical properties of these prices. Second, we apply our method to price options in the presence of stochastic volatility. Our main contribution to this problem is to show that the instantaneous Sharpe ratio, an integral ingredient in our methodology, is the negative of the market price of volatility risk, as defined in Fouque, Papanicolaou, and Sircar (2000).

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File URL: http://hdl.handle.net/10.1007/s10436-007-0084-0
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Article provided by Springer in its journal Annals of Finance.

Volume (Year): 4 (2008)
Issue (Month): 4 (October)
Pages: 399-429

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Handle: RePEc:kap:annfin:v:4:y:2008:i:4:p:399-429
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  1. Marek Musiela & Thaleia Zariphopoulou, 2004. "An example of indifference prices under exponential preferences," Finance and Stochastics, Springer, vol. 8(2), pages 229-239, 05.
  2. Schweizer, Martin, 2001. "From actuarial to financial valuation principles," Insurance: Mathematics and Economics, Elsevier, vol. 28(1), pages 31-47, February.
  3. Tim Leung & Ronnie Sircar, 2009. "Accounting For Risk Aversion, Vesting, Job Termination Risk And Multiple Exercises In Valuation Of Employee Stock Options," Mathematical Finance, Wiley Blackwell, vol. 19(1), pages 99-128.
  4. Virginia R. Young, 2007. "Pricing Life Insurance under Stochastic Mortality via the Instantaneous Sharpe Ratio: Theorems and Proofs," Papers 0705.1297, arXiv.org.
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