Utility-Based Pricing, Timing and Hedging of an American Call Option Under an Incomplete Market with Partial Information

24 Pages Posted: 19 Mar 2012

See all articles by Dandan Song

Dandan Song

Hunan University - School of Finance and Statistics

Zhaojun Yang

Southern University of Science and Technology - Department of Finance

Date Written: March 18, 2012

Abstract

This paper studies the pricing, timing and hedging of an American call option written on a non-tradable asset whose mean appreciation rate is not observable but is known to be a Gaussian random variable. Our goal is to analyze the effects of the partial information on investment in the American option under an incomplete market. The objective of the option holder is to maximize the expected discounted utility of consumption over an infinite lifetime. Thanks to consumption utility-based indifference pricing principal, stochastic control and filtering theory, under CARA utility, we derive the value and the exercise time of the American call option, which are determined by a semi-closed-form solution of a free-boundary PDE problem with a finite time horizon. We provide numerical results by finite difference methods and compare the results with those under a fully observable case. Numerical calculations demonstrate that partial information leads to a significant loss of the implied value of the American call option. This loss increases with the uncertainty of the mean appreciation rate. If the option holder is risk-averse enough, a growth of the systematic/idiosyncratic risk will increase/decrease the implied option value and the option is exercised late/early. Whether a stronger positive correlation between the tradable asset and the non-tradable underlying asset increases the option value and the information value depends on the risk attitude of the option holder. But on the contrary, a stronger negative correlation will definitely make the option and the information more valuable. In addition, as a corollary of our results, explicit expressions of the utility-based pricing for a perpetual American call are presented if the tradable risky asset is perfectly correlated with the underlying asset.

Keywords: Partial information, American option, Consumption utility-based indifference pricing, incomplete market

JEL Classification: C61, G13

Suggested Citation

Song, Dandan and Yang, Zhaojun, Utility-Based Pricing, Timing and Hedging of an American Call Option Under an Incomplete Market with Partial Information (March 18, 2012). Available at SSRN: https://ssrn.com/abstract=2025393 or http://dx.doi.org/10.2139/ssrn.2025393

Dandan Song

Hunan University - School of Finance and Statistics ( email )

School of Finance and Statistics
Changsha, CA 410079
China

Zhaojun Yang (Contact Author)

Southern University of Science and Technology - Department of Finance ( email )

No 1088, Xueyuan Rd.
District of Nanshan
Shenzhen, Guangdong 518055
China

HOME PAGE: http://faculty.sustc.edu.cn/profiles/yangzj

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