A Theory of Equivalent Expectation Measures for Contingent Claim Returns

100 Pages Posted: 27 Oct 2020 Last revised: 24 May 2022

See all articles by Sanjay K. Nawalkha

Sanjay K. Nawalkha

University of Massachusetts Amherst - Isenberg School of Management

Xiaoyang Zhuo

Beijing Institute of Technology - School of Management and Economics

Date Written: June 26, 2020

Abstract

This paper introduces a dynamic change of measure approach for computing the analytical solutions of expected future prices (and therefore, expected returns) of contingent claims over a finite horizon. The new approach constructs hybrid probability measures called the “equivalent expectation measures” (EEMs), which provide the physical expectation of the claim’s future price until before the horizon date, and serve as pricing measures on or after the horizon date. The EEM theory can be used for empirical investigations of both the cross-section and the term structure of returns of contingent claims, such as Treasury bonds, corporate bonds, and financial derivatives.

Keywords: Dynamic change of measure, Equivalent expectation measure, Expected returns, Risk-neutral valuation, Contingent claims

JEL Classification: G12, G13

Suggested Citation

Nawalkha, Sanjay K. and Zhuo, Xiaoyang, A Theory of Equivalent Expectation Measures for Contingent Claim Returns (June 26, 2020). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3636202 or http://dx.doi.org/10.2139/ssrn.3636202

Sanjay K. Nawalkha

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States

Xiaoyang Zhuo (Contact Author)

Beijing Institute of Technology - School of Management and Economics ( email )

5 South Zhongguancun Street
Haidian District
Beijing, Beijing 100081
China

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