Utility indifference valuation for non-smooth payoffs with an application to power derivatives

Giuseppe Benedetti and Luciano Campi

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We consider the problem of exponential utility indifference valuation under the simplified framework where traded and nontraded assets are uncorrelated but where the claim to be priced possibly depends on both. Traded asset prices follow a multivariate Black and Scholes model, while nontraded asset prices evolve as generalized Ornstein–Uhlenbeck processes. We provide a BSDE characterization of the utility indifference price (UIP) for a large class of non-smooth, possibly unbounded, payoffs depending simultaneously on both classes of assets. Focusing then on Vanilla claims and using the Gaussian structure of the model allows us to employ some BSDE techniques (in particular, a Malliavin-type representation theorem due to Ma and Zhang, Ann Appl Probab 12:1390–1418, 2002) to prove the regularity of Z and to characterize the UIP for possibly discontinuous Vanilla payoffs as a viscosity solution of a suitable PDE with continuous space derivatives. The optimal hedging strategy is also identified essentially as the delta hedging strategy corresponding to the UIP. Since there are no closed-form formulas in general, we also obtain asymptotic expansions for prices and hedging strategies when the risk aversion parameter is small. Finally, our results are applied to pricing and hedging power derivatives in various structural models for energy markets

Keywords: Utility indifference pricing; optimal investment; backward stochastic differential equations; viscosity solutions; electricity markets (search for similar items in EconPapers)
JEL-codes: C1 F3 G3 (search for similar items in EconPapers)
Date: 2016-04
New Economics Papers: this item is included in nep-ore and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

Published in Applied Mathematics and Optimization, April, 2016, 73(2), pp. 349-389. ISSN: 0095-4616

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