Asset Pricing Theory for Two Price Economies

37 Pages Posted: 25 Mar 2014

See all articles by Dilip B. Madan

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Date Written: March 01, 2014

Abstract

We show that nonlinearly discounted nonlinear martingales are related to no arbitrage in two price economies as linearly discounted martingales were related to no arbitrage in economies satisfying the law of one price. Furthermore, assuming risk acceptability requires a positive physical expectation, we demonstrate that expected rates of return on ask prices should be dominated by expected rates of return on bid prices. A preliminary investigation conducted here, supports this hypothesis. In general we observe that asset pricing theory in two price economies leads to asset pricing inequalities. A model incorporating both nonlinear discounting and nonlinear martingales is developed for the valuation of contingent claims in two price economies. Examples illustrate the interactions present between the severity of measure changes and their associated discount rates. As a consequence arbitrage free two price economies can involve unique discount curves and measure changes that are however specific to both the product being priced and the trade direction.

Keywords: Multi-curve discounting, Acceptable Risks, Distorted Expectations, Cliquets, DVA

JEL Classification: G10, G11, G12

Suggested Citation

Madan, Dilip B., Asset Pricing Theory for Two Price Economies (March 01, 2014). Robert H. Smith School Research Paper No. RHS 2414134, Available at SSRN: https://ssrn.com/abstract=2414134 or http://dx.doi.org/10.2139/ssrn.2414134

Dilip B. Madan (Contact Author)

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)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
234
Abstract Views
1,142
rank
159,213
PlumX Metrics