Spanning and Derivative-Security Valuation

34 Pages Posted: 7 Apr 1999

See all articles by Dilip B. Madan

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Gurdip Bakshi

Fox School of Business; Temple University - Fox School of Business and Management

Multiple version iconThere are 2 versions of this paper

Abstract

This paper proposes a methodology for the valuation of contingent securities. In particular, it establishes how the characteristic function (of the future uncertainty) is basis augmenting and spans the payoff universe of most, if not all, derivative assets. In one specific application, from the characteristic function of the state-price density, it is possible to analytically price options on any arbitrary transformation of the underlying uncertainty. By differentiating (or translating) the characteristic function, limitless pricing and/or spanning opportunities can be designed. As made lucid via example contingent claims, by exploiting the unifying spanning concept, the valuation approach affords substantial analytical tractability. The strength and versatility of the methodology is inherent when valuing (1) Average-interest options; (2) Correlation options; and (3) Discretely-monitored knock-out options. For each option-like security, the characteristic function is strikingly simple (although the corresponding density is unmanageable/indeterminate). This article provides the economic foundations for valuing derivative securities.

JEL Classification: G10, G12, G13

Suggested Citation

Madan, Dilip B. and Bakshi, Gurdip S. and Bakshi, Gurdip S., Spanning and Derivative-Security Valuation. Available at SSRN: https://ssrn.com/abstract=153908 or http://dx.doi.org/10.2139/ssrn.153908

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

Gurdip S. Bakshi (Contact Author)

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

Temple University - Fox School of Business and Management ( email )

Philadelphia, PA 19122
United States

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

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