Expectation and Price in Incomplete Markets

31 Pages Posted: 8 Sep 2020

See all articles by Paul McCloud

Paul McCloud

University College London - Department of Mathematics

Date Written: June 30, 2020

Abstract

Risk-neutral pricing dictates that the discounted derivative price is a martingale in a measure equivalent to the economic measure. The residual ambiguity for incomplete markets is here resolved by minimizing the entropy of the price measure from the economic measure, subject to mark-to-market constraints, following arguments based on the optimization of portfolio risk. The approach accounts for market and funding convexities and incorporates available price information, interpolating between methodologies based on expectation and replication.

Keywords: Derivative Pricing, Funding, Discounting, Incomplete Markets, Portfolio Optimization, Entropy, Levy-Khintchine Representation

JEL Classification: G11, G12, G13, G14

Suggested Citation

McCloud, Paul, Expectation and Price in Incomplete Markets (June 30, 2020). Available at SSRN: https://ssrn.com/abstract=3661764 or http://dx.doi.org/10.2139/ssrn.3661764

Paul McCloud (Contact Author)

University College London - Department of Mathematics ( email )

Gower Street
London, WC1E 6BT
United Kingdom

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