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Utility-Based Pricing, Timing and Hedging of an American Call Option Under an Incomplete Market with Partial Information

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  • Dandan Song

    ()

  • Zhaojun Yang

    ()

Abstract

This paper studies the pricing, timing and hedging of an American call option written on a non-tradable asset whose mean appreciation rate is not observable but is known to be a Gaussian random variable. Our goal is to analyze the effects of the partial information on investment in the American option under an incomplete market. The objective of the option holder is to maximize the expected discounted utility of consumption over an infinite lifetime. Thanks to consumption utility-based indifference pricing principal, stochastic control and filtering theory, under CARA utility, we derive the value and the exercise time of the American call option, which are determined by a semi-closed-form solution of a free-boundary PDE problem with a finite time horizon. We provide numerical results by finite difference methods and compare the results with those under a fully observable case. Numerical calculations demonstrate that partial information leads to a significant loss of the implied value of the American call option. This loss increases with the uncertainty of the mean appreciation rate. If the option holder is risk-averse enough, a growth of the systematic/idiosyncratic risk will increase/decrease the implied option value and the option is exercised later/sooner. Whether a stronger positive correlation between the tradable asset and the non-tradable underlying asset increases the option value and the information value depends on the risk attitude of the option holder. On the contrary, a stronger negative correlation will definitely make the option and the information more valuable. In addition, explicit expressions of the utility-based pricing for a perpetual American call are presented if the tradable risky asset is perfectly correlated with the underlying asset. Copyright Springer Science+Business Media New York 2014

Suggested Citation

  • Dandan Song & Zhaojun Yang, 2014. "Utility-Based Pricing, Timing and Hedging of an American Call Option Under an Incomplete Market with Partial Information," Computational Economics, Springer;Society for Computational Economics, vol. 44(1), pages 1-26, June.
  • Handle: RePEc:kap:compec:v:44:y:2014:i:1:p:1-26
    DOI: 10.1007/s10614-013-9382-y
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    References listed on IDEAS

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    1. Décamps, Jean-Paul & Mariotti, Thomas & Villeneuve, Stéphane, 2000. "Investment Timing under Incomplete Information," IDEI Working Papers 115, Institut d'Économie Industrielle (IDEI), Toulouse, revised Apr 2004.
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    Cited by:

    1. R. Kalantari & S. Shahmorad & D. Ahmadian, 2016. "The Stability Analysis of Predictor–Corrector Method in Solving American Option Pricing Model," Computational Economics, Springer;Society for Computational Economics, vol. 47(2), pages 255-274, February.

    More about this item

    Keywords

    Partial information; American option; Consumption utility-based indifference pricing; Incomplete market; C61; G13;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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