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Pricing and Hedging Options in Incomplete Markets: Idiosyncratic Risk, Systematic Risk and Stochastic Volatility

Author

Listed:
  • Gatfaoui Hayette

    (University Paris I - Panthéon-Sorbonne)

  • Chauveau Thierry

    (University Paris I - Panthéon-Sorbonne)

Abstract

Starting from the European option valuation framework of Chauveau & Gatfaoui (2002), we establish the link with stochastic volatility models. And, we propose both a new vision and a general framework for valuing European options in the light of systematic and idiosyncratic risks affecting risky assets in the financial market. Therefore, we account for the well-known volatility smile in the light of the literature addressing the determinants of the smile effect among which stochastic volatility and market risk. We further discuss briefly the hedging of European options along with the local risk minimization principle. Specifically, we attempt to find a strategy, which dominates the usual partial hedging technique often imposed by market’s incompleteness.

Suggested Citation

  • Gatfaoui Hayette & Chauveau Thierry, 2004. "Pricing and Hedging Options in Incomplete Markets: Idiosyncratic Risk, Systematic Risk and Stochastic Volatility," Finance 0404002, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0404002
    Note: Type of Document - pdf; pages: 26
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    References listed on IDEAS

    as
    1. Rüdiger Frey & Carlos A. Sin, 1999. "Bounds on European Option Prices under Stochastic Volatility," Mathematical Finance, Wiley Blackwell, vol. 9(2), pages 97-116, April.
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    5. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305, World Scientific Publishing Co. Pte. Ltd..
    6. Vicky Henderson, 2002. "Analytical Comparisons of Option prices in Stochastic Volatility Models," OFRC Working Papers Series 2002mf03, Oxford Financial Research Centre.
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    More about this item

    Keywords

    Call pricing; idiosyncratic risk; incomplete market; stochastic volatility; systematic risk.;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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