Risk and Valuation Theory of Markets

12 Pages Posted: 28 Dec 2014 Last revised: 22 Feb 2016

Date Written: December 26, 2014

Abstract

Trade and commerce in financial instruments such as stocks, bonds and contingent claims with the goal of exchanging future cash flows is as old as commerce itself. Commerce would be empty and meaningless without a clear perception of risk, thus the principal questions pertaining to commerce are: What is return? What is risk? What constitutes risk? How do you quantify risks and what measurement do you use? In particular, whose risks do you quantify and manage? What are then the fair market value for stock, bond and contingent claims? What principles do you use to answer these questions? From the rich history of modern finance, the risk-neutral valuation theory was established. Despite the qualitative nature we argue that the theory offers no answers to the questions, consequently the theory cannot be validated and operational in real financial markets. In this article we approach the questions by exploring the definition of risk: Risk is exposure to contingency the conditions of which are uncertain - uncertainty lies in our capacity including perception, intuition, knowledge and skill to {\it identify} and {\it quantify} the material impacts of such conditions to which we are exposed. By definition we identify contingent event or claim as risk. We conjecture that there exist intrinsic risks inherent in every contingent claim, in consequence we argue and establish a new framework that offers concrete implications for the practice of risk valuation and management, the risk-subjective valuation theory.

Keywords: risk; uncertainty; contingent claim; intrinsic risk; risk-subjective expectation; efficient markets; put-call parity; valuation theory

JEL Classification: C6

Suggested Citation

Le, Truc, Risk and Valuation Theory of Markets (December 26, 2014). Available at SSRN: https://ssrn.com/abstract=2543049 or http://dx.doi.org/10.2139/ssrn.2543049

Truc Le (Contact Author)

Independent ( email )

No Address Available

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