Forward versus Spot Price Modeling

Jan-Frederik Mai

Chapter 16 in Innovations in Insurance, Risk- and Asset Management:Proceedings of the Innovations in Insurance, Risk- and Asset Management Conference, 2018, pp 399-420 from World Scientific Publishing Co. Pte. Ltd.

Abstract: It is possible to base an equity derivatives pricing model on a stochastic driving process for the share price (spot), or for the equity forward. While the former is the classical approach pioneered by Black and Scholes [9], the latter approach separates the modeling of exogenous random price fluctuations from the cost-of-carry modeling of the stock, probably the first and most prominent example of this technique being the paper by Black [8]. While the Black—Scholes spot price approach and Black’s forward approach are equivalent, the present note demonstrates that the introduction of local volatility and/ or level-dependent default intensity into the stochastic driving process destroys this equivalence, if applied carelessly. The advantages and disadvantages of both approaches are discussed.

Keywords: Insurance; Actuarial Science; Risk Measure; Reinsurance; Copula; Replicating Portfolio; Bayesian Finance; Risk Classification; Stochastic Dominance; Dynamic Hedging; Autoregressive Hidden Markov Models; Exchange-Traded Funds; Uncertainty Quantification; Fixed Income; Stochastic Processes for Finance (search for similar items in EconPapers)
JEL-codes: G22 G32 (search for similar items in EconPapers)
Date: 2018
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