The Mathematical Institute, University of Oxford, Eprints Archive

Utility-based valuation and hedging of basis risk with partial information

Monoyios, Michael Utility-based valuation and hedging of basis risk with partial information. Applied Mathematical Finance . (Submitted)

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Abstract

We analyse the valuation and hedging of a claim on a non-traded asset using a correlated traded asset under a partial information scenario, when the asset drifts are unknown constants. Using a Kalman filter and a Gaussian prior distribution for the unknown parameters, a full information model with random drifts is obtained. This is subjected to exponential indifference valuation. An expression for the optimal hedging strategy is derived. An asymptotic expansion for small values of risk aversion is obtained via PDE methods, following on from payoff decompositions and a price representation equation. Analytic and semi-analytic formulae for the terms in the expansion are obtained when the minimal entropy measure coincides with the minimal martingale measure. Simulation experiments are carried out which indicate that the filtering procedure can be beneficial in hedging, but sometimes needs to be augmented with the increased option premium, that takes into account parameter uncertainty, in order to be effective. Empirical examples are presented which conform to these conclusions.

Item Type:Article
Subjects:O - Z > Probability theory and stochastic processes
Research Groups:Mathematical and Computational Finance Group
ID Code:796
Deposited By:Michael Monoyios
Deposited On:01 Sep 2009 08:33
Last Modified:01 Sep 2009 08:33

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