Beyond Arbitrage: 'Good Deal' Asset Price Bounds in Incomplete Markets

CRSP Working Paper No. 430

63 Pages Posted: 26 Jun 1998

See all articles by John H. Cochrane

John H. Cochrane

Hoover Institution; National Bureau of Economic Research (NBER)

Jesus Saa-Requejo

Vega Asset Management LLC

Multiple version iconThere are 2 versions of this paper

Date Written: January 1998

Abstract

One often wants to value a given asset or risky payoff by reference to observed prices of other assets rather than by exploiting full-fledged economic models. However, this approach breaks down if one cannot find a perfect replicating portfolio. We impose weak economic restrictions to derive usefully tight bounds on asset prices in this situation. The bounds basically rule out high Sharpe ratios - "good deals" - as well as arbitrage opportunities. We show how to calculate the price bounds in two-period, multiperiod and continuous time contexts. We show that the multiperiod problem can be solved recursively as a sequence of two-period problems. We calculate bounds in option pricing examples including infrequent trading, an option written on a nontraded event, and in an environment with stochastic stock volatility and a varying riskfree rate.

JEL Classification: G12, G13

Suggested Citation

Cochrane, John H. and Saa-Requejo, Jesus, Beyond Arbitrage: 'Good Deal' Asset Price Bounds in Incomplete Markets (January 1998). CRSP Working Paper No. 430, Available at SSRN: https://ssrn.com/abstract=7348 or http://dx.doi.org/10.2139/ssrn.7348

John H. Cochrane (Contact Author)

Hoover Institution ( email )

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National Bureau of Economic Research (NBER)

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Jesus Saa-Requejo

Vega Asset Management LLC ( email )

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Madrid
Spain

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