Decreasing absolute risk aversion and option pricing bounds

Decreasing absolute risk aversion and option pricing bounds

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Article ID: iaor1998698
Country: United States
Volume: 43
Issue: 2
Start Page Number: 206
End Page Number: 216
Publication Date: Feb 1997
Journal: Management Science
Authors: ,
Keywords: investment, programming: mathematical
Abstract:

In this paper efficient bounds for the price of a call option are obtained using the decreasing absolute risk aversion (DARA) dominance rule. Such lower and upper bounds are obtained minimizing and maximizing, respectively, the objective function of a nonlinear optimization problem. An explicit formula (related to an exponential utility function) is given for the special case of three states of nature. A large number of experiments have been carried out and the numerical results support the conjecture that the same formula holds for problems with a number of states n > 3. Moreover, DARA bounds are more efficient than the bounds obtained using different criteria.

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