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http://ssrn.com/abstract=40861
 
 

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An Alternative Valuation Model for Contingent Claims


Zhiwu Chen


Yale University - International Center for Finance; Zebra Capital Management, LLC

Gurdip Bakshi


University of Maryland - Robert H. Smith School of Business

September 1995

THE CHARLES A. DICE CENTER FOR RESEARCH IN FINANCIAL ECONOMICS

Abstract:     
The fundamental valuation equation of Cox, Ingersoll and Ross was expressed in terms of the indirect utility of wealth function. As closed-form solution for the indirect utility is generally
unobtainable when investment opportunities are stochastic, existing contingent claims models involving general stochastic processes were almost all derived under the restrictive log utility assumption. An alternative valuation equation is proposed here that depends only on the direct utility function. This alternative valuation approach is applied to derive closed-form
solutions for bonds, bond options, individual stocks, and stock options under both power utility and exponential utility functions. Allowable processes for aggregate output, firms' dividends, and state variables are quite general and empirically plausible. The resulting interest rate and stock price dynamics have many empirically plausible properties. Our bond and stock option pricing models with stochastic volatility and stochastic interest rates have most existing models nested. The stock option pricing model is also shown to have the ability to reconcile certain puzzling empirical regularities such as the volatility smile.

Number of Pages in PDF File: 36

JEL Classification: G13

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Date posted: February 29, 1996  

Suggested Citation

Chen, Zhiwu and Bakshi, Gurdip, An Alternative Valuation Model for Contingent Claims (September 1995). THE CHARLES A. DICE CENTER FOR RESEARCH IN FINANCIAL ECONOMICS. Available at SSRN: http://ssrn.com/abstract=40861 or http://dx.doi.org/10.2139/ssrn.40861

Contact Information

Zhiwu Chen
Yale University - International Center for Finance ( email )
Box 208200
New Haven, CT 06520-8200
United States
203-432-5948 (Phone)
203-432-6970 (Fax)
Zebra Capital Management, LLC ( email )
612 Wheelers Farms Road
Milford, CT 06461
United States
Gurdip S. Bakshi (Contact Author)
University of Maryland - Robert H. Smith School of Business ( email )
Department of Finance
College Park, MD 20742-1815
United States
301-405-2261 (Phone)
301-314-9157 (Fax)
HOME PAGE: http://www.rhsmith.umd.edu/finance/gbakshi
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