Martingale Pricing

Posted: 12 Nov 2010

See all articles by Kerry Back

Kerry Back

Rice University - Jesse H. Jones Graduate School of Business

Date Written: December 2010

Abstract

The fact that properly normalized asset prices are martingales is the basis of modern asset pricing. One normalizes asset prices to adjust for risk and time preferences. Both adjustments can be made simultaneously via a stochastic discount factor, or one can adjust for risk by changing probabilities and adjust for time using the return on an asset, for example, the risk-free return. This paper reviews this methodology and the circumstances in which it is feasible. Three examples are given to illustrate the delicate link in continuous-time models between the absence of arbitrage opportunities and the feasibility of martingale pricing.

Suggested Citation

Back, Kerry, Martingale Pricing (December 2010). Annual Review of Financial Economics, Vol. 2, pp. 235-250, 2010, Available at SSRN: https://ssrn.com/abstract=1707920 or http://dx.doi.org/10.1146/annurev-financial-073009-104041

Kerry Back (Contact Author)

Rice University - Jesse H. Jones Graduate School of Business ( email )

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P.O. Box 1892
Houston, TX 77005-1892
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