Article ID: | iaor20116863 |
Volume: | 8 |
Issue: | 3 |
Start Page Number: | 299 |
End Page Number: | 321 |
Publication Date: | Aug 2011 |
Journal: | Computational Management Science |
Authors: | Pinar |
Keywords: | risk |
We present an approach for pricing and hedging in incomplete markets, which encompasses other recently introduced approaches for the same purpose. In a discrete time, finite space probability framework conducive to numerical computation we introduce a gain–loss ratio based restriction controlled by a loss aversion parameter, and characterize portfolio values which can be traded in discrete time to acceptability. The new risk measure specializes to a well‐known risk measure (the Carr–Geman–Madan risk measure) for a specific choice of the risk aversion parameter, and to a robust version of the gain–loss measure (the Bernardo–Ledoit proposal) for a specific choice of thresholds. The result implies potentially tighter price bounds for contingent claims than the no‐arbitrage price bounds. We illustrate the price bounds through numerical examples from option pricing.