TENOR SPECIFIC PRICING

Dilip B. Madan () and Wim Schoutens ()
Additional contact information
Dilip B. Madan: Robert H. Smith School of Business, University of Maryland, College Park, MD 20742, USA
Wim Schoutens: Department of Mathematics, K.U. Leuven, Celestijnenlaan 200B, B-3001 Leuven, Belgium

International Journal of Theoretical and Applied Finance (IJTAF), 2012, vol. 15, issue 06, 1-21

Abstract: Observing that pure discount projection curves are now based on a variety of tenors leads us to enquire into the possibility of theoretically deriving tenor specific zero coupon bond prices. The question then also arises on how to construct tenor specific prices for all financial contracts. Noting that in conic finance one has the law of two prices, bid and ask, that are nonlinear functions of the random variables being priced, we model dynamically consistent sequences of such prices using the theory of nonlinear expectations. The latter theory is closely connected to solutions of backward stochastic difference equations. The drivers for these stochastic difference equations are here constructed using concave distortions that implement risk charges for local tenor specific risks. It is then observed that tenor specific prices given by the mid quotes of bid and ask converge to the risk neutral price as the tenor is decreased and liquidity increased when risk charges are scaled by the tenor. Square root tenor scaling can halt the convergence to risk neutral pricing, preserving bid ask spreads in the limit. The greater liquidity of lower tenors may lead to an increase or decrease in prices depending on whether the lower liquidity of a higher tenor has a mid quote above or below the risk neutral value. Generally for contracts with a large upside and a bounded downside the prices fall with liquidity while the opposite is the case for contracts subject to a large downside and a bounded upside.

Keywords: Acceptable risks; nonlinear expectations; distorted expectations; CIR spot rate model (search for similar items in EconPapers)
Date: 2012
References: View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024912500434
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:15:y:2012:i:06:n:s0219024912500434

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024912500434

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().