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A Note On Utility Indifference Pricing

Author

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  • JOHANNES GERER

    (University of Regensburg, Department of Finance, 93040 Regensburg, Germany)

  • GREGOR DORFLEITNER

    (University of Regensburg, Department of Finance, 93040 Regensburg, Germany)

Abstract

Utility-based valuation methods are enjoying growing popularity among researchers as a means to overcome the challenges in contingent claim pricing posed by the many sources of market incompleteness. However, we show that under the most common utility functions (including CARA and CRRA), any realistic and actually practicable hedging strategy involving a possible short position has infinitely negative utility. We then demonstrate for utility indifference prices (and also for the related so-called utility-based (marginal) prices) how this problem leads to a severe divergence between results obtained under the assumption of continuous trading and realistic results. The combination of continuous trading and common utility functions is thus not justified in these methods, raising the question of whether and how results obtained under such assumptions could be put to real-world use.

Suggested Citation

  • Johannes Gerer & Gregor Dorfleitner, 2016. "A Note On Utility Indifference Pricing," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(06), pages 1-17, September.
  • Handle: RePEc:wsi:ijtafx:v:19:y:2016:i:06:n:s0219024916500370
    DOI: 10.1142/S0219024916500370
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    References listed on IDEAS

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    Cited by:

    1. Alet Roux & Zhikang Xu, 2019. "Optimal investment and contingent claim valuation with exponential disutility under proportional transaction costs," Papers 1909.06260, arXiv.org, revised May 2021.

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