Asset pricing theory for two price economies
Dilip Madan ()
Annals of Finance, 2015, vol. 11, issue 1, 35 pages
Abstract:
We show that nonlinearly discounted nonlinear martingales are related to no arbitrage in two price economies as linearly discounted martingales were related to no arbitrage in economies satisfying the law of one price. Furthermore, assuming risk acceptability requires a positive physical expectation, we demonstrate that expected rates of return on ask prices should be dominated by expected rates of return on bid prices. A preliminary investigation conducted here, supports this hypothesis. In general we observe that asset pricing theory in two price economies leads to asset pricing inequalities. A model incorporating both nonlinear discounting and nonlinear martingales is developed for the valuation of contingent claims in two price economies. Examples illustrate the interactions present between the severity of measure changes and their associated discount rates. As a consequence arbitrage free two price economies can involve unique discount curves and measure changes that are however specific to both the product being priced and the trade direction. Furthermore the developed valuation operators call into question the current practice of Debt Valuation Adjustments. Copyright Springer-Verlag Berlin Heidelberg 2015
Keywords: Multi-curve discounting; Acceptable risks; Distorted expectations; Cliquets; Debt valuation adjustments; G10; G11; G13 (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (15)
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Persistent link: https://EconPapers.repec.org/RePEc:kap:annfin:v:11:y:2015:i:1:p:1-35
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DOI: 10.1007/s10436-014-0255-8
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