Option-Pricing in Incomplete Markets: The Hedging Portfolio Plus a Risk Premium-Based Recursive Approach

Posted: 31 Mar 2007

Date Written: February 2005

Abstract

Consider a non-spanned security C_T in an incomplete market. We study the risk/return trade-offs generated if this security is sold for an arbitrage-free price 'c0' and then hedged. We consider recursive one-period optimal self-financing hedging strategies, a simple but tractable criterion. For continuous trading, diffusion processes, the one-period minimum variance portfolio is optimal. Let C_0(0) be its price. Self-financing implies that the residual risk is equal to the sum of the one-period orthogonal hedging errors, \sum Y_t(0) . To compensate the residual risk, a risk premium y_t ?t is associated with every Y_t. Now let C_0(y) be the price of the hedging portfolio, and \sum (Y_t(y) + y_t ?t) is the total residual risk. Although not the same, the one-period hedging errors Y_t (0) and Y_t (y) are orthogonal to the trading assets, and are perfectly correlated. This implies that the spanned option payoff does not depend on y. Let c0=C_0(y). A main result follows. Any arbitrage-free price, c0, is just the price of a hedging portfolio (such as in a complete market), C_0(0), plus a premium, c0-C_0(0). That is, C_0(0) is the price of the option's payoff which can be spanned, and c0-C_0(0) is the premium associated with the option's payoff which cannot be spanned (and yields a contingent risk premium of \sum y_t ?t at maturity). We study other applications of option-pricing theory as well.

Keywords: option pricing, incomplete markets, hedging, risk premium

JEL Classification: G12, G13, G22

Suggested Citation

Ibañez, Alfredo, Option-Pricing in Incomplete Markets: The Hedging Portfolio Plus a Risk Premium-Based Recursive Approach (February 2005). Available at SSRN: https://ssrn.com/abstract=674622 or http://dx.doi.org/10.2139/ssrn.674622

Alfredo Ibañez (Contact Author)

Comillas Pontifical University ( email )

Alberto Aguilera 21
Madrid, Madrid 28015
Spain

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