Template-Type:ReDIF-Paper 1.0  
Title: Pseudo--Arbitrage - A new Approach to Pricing and Hedging in Incomplete Markets
Author-Name:  Daniel Sommer
Classification-JEL: G12 G13
Keywords: arbitrage, pseudo--arbitrage, pricing of contingent claims, hedging,
 incomplete markets, stochastic volatility
Abstract: We develop a new approach to pricing and hedging
 contingent claims in incomplete markets. Mimicking as closely as
 possible in an incomplete markets framework the no--arbitrage
 arguments that have been developed in complete markets leads us to
 defining the concept of pseudo--arbitrage. Building on this
 concept we are able to extend the no--arbitrage idea to a world of
 incomplete markets in such a way that  based on a concept of risk
 compatible with the axioms of Artzner et al. we can derive unique
 prices and corresponding optimal hedging strategies without
 invoking specific assumptions on preferences (other than
 monotonicity and risk aversion). Price processes of contingent
 claims are martingales under a unique martingale measure. A
 comparison to a version of the Hull and White stochastic
 volatility model shows that in contrast to their approach
 explicitly taking into account optimal hedging strategies leads to
 positive market prices of risk for volatility even if the latter
 is instantaneously uncorrelated with the stock price process. Our
 results are, however, in agreement with the findings of Lamoureux
 and Lastrapes.
Length: 38 pages
Creation-Date: 1998-11
Revision-Date: 
Handle: RePEc:bon:bonsfb:442
File-URL: http://www.wiwi.uni-bonn.de/bgsepapers/bonsfb/bonsfb442.pdf
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