Pricing and Hedging Basis Risk under No Good Deal Assumption
We consider the problem of pricing and hedging an option written on a non-exchangeable asset when trading in a correlated asset is possible. This is a typical case of incomplete market where it is well known that the super-replication concept provides generally too high prices. Here, following J.H. Cochrane and J. Saá-Requejo, we study valuation under No Good Deal (NGD) Assumption. First, we clarify the notion of NGD for dynamic strategies, compute a lower and an upper bound and prove that in fact NGD price can be strictly higher that the one previously compute in the literature. We also propose a hedging strategy by imposing criterium on the variance of the replication's error. Finally, we provide various numerical illustrations showing the efficiency of NGD pricing and hedging.
|Date of creation:||07 Jul 2010|
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- Erhan Bayraktar & Virginia Young, 2008.
"Pricing options in incomplete equity markets via the instantaneous Sharpe ratio,"
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