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A solution approach to valuation with unhedgeable risks

Author

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  • Thaleia Zariphopoulou

    () (School of Business and Department of Mathematics, University of Wisconsin Madison, WI 53706, USA Manuscript)

Abstract

We study a class of stochastic optimization models of expected utility in markets with stochastically changing investment opportunities. The prices of the primitive assets are modelled as diffusion processes whose coefficients evolve according to correlated diffusion factors. Under certain assumptions on the individual preferences, we are able to produce reduced form solutions. Employing a power transformation, we express the value function in terms of the solution of a linear parabolic equation, with the power exponent depending only on the coefficients of correlation and risk aversion. This reduction facilitates considerably the study of the value function and the characterization of the optimal hedging demand. The new results demonstrate an interesting connection with valuation techniques using stochastic differential utilities and also, with distorted measures in a dynamic setting.

Suggested Citation

  • Thaleia Zariphopoulou, 2001. "A solution approach to valuation with unhedgeable risks," Finance and Stochastics, Springer, vol. 5(1), pages 61-82.
  • Handle: RePEc:spr:finsto:v:5:y:2001:i:1:p:61-82
    Note: received: January 1999; final version received: February 2000
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    More about this item

    Keywords

    Non-traded assets; stochastic factors; unhedgeable risks; portfolio management; reduced form solutions;

    JEL classification:

    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
    • D9 - Microeconomics - - Micro-Based Behavioral Economics
    • G1 - Financial Economics - - General Financial Markets

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