Beyond Arbitrage: "Good-Deal" Asset Price Bounds in Incomplete Markets

70 Pages Posted: 19 Jul 2000 Last revised: 3 Jul 2022

See all articles by John H. Cochrane

John H. Cochrane

Hoover Institution; National Bureau of Economic Research (NBER)

Jesus Saa-Requejo

Vega Asset Management LLC

Date Written: March 1996

Abstract

It is often useful to price assets and other random payoffs by reference to other observed prices rather than construct full-fledged economic asset pricing models. This approach breaks down if one cannot find a perfect replicating portfolio. We impose weak economic restrictions to derive usefully tight bounds on asset prices in this situation. The bounds basically rule out high Sharpe ratios - `good deals' - as well as arbitrage opportunities. We present the method of calculation, we extend it to a multiperiod context by finding a recursive solution, and we apply it to option pricing examples including the Black-Scholes setup with infrequent trading, and a model with stochastic stock volatility and a varying riskfree rate.

Suggested Citation

Cochrane, John H. and Saa-Requejo, Jesus, Beyond Arbitrage: "Good-Deal" Asset Price Bounds in Incomplete Markets (March 1996). NBER Working Paper No. w5489, Available at SSRN: https://ssrn.com/abstract=225520

John H. Cochrane (Contact Author)

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Jesus Saa-Requejo

Vega Asset Management LLC ( email )

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Madrid
Spain

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