Modelling Derivatives Pricing Mechanisms with Their Generating Functions

Shige Peng

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Abstract: In this paper we study dynamic pricing mechanisms of financial derivatives. A typical model of such pricing mechanism is the so-called g--expectation defined by solutions of a backward stochastic differential equation with g as its generating function. Black-Scholes pricing model is a special linear case of this pricing mechanism. We are mainly concerned with two types of pricing mechanisms in an option market: the market pricing mechanism through which the market prices of options are produced, and the ask-bid pricing mechanism operated through the system of market makers. The later one is a typical nonlinear pricing mechanism. Data of prices produced by these two pricing mechanisms are usually quoted in an option market. We introduce a criteria, i.e., the domination condition (A5) in (2.5) to test if a dynamic pricing mechanism under investigation is a g--pricing mechanism. This domination condition was statistically tested using CME data documents. The result of test is significantly positive. We also provide some useful characterizations of a pricing mechanism by its generating function.

Date: 2006-05
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