Beyond Arbitrage: "Good-Deal" Asset Price Bounds in Incomplete Markets

John Cochrane and Jesus Saa-Requejo

No 5489, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: It is often useful to price assets and other random payoffs by reference to other observed prices rather than construct full-fledged economic asset pricing models. This approach breaks down if one cannot find a perfect replicating portfolio. We impose weak economic restrictions to derive usefully tight bounds on asset prices in this situation. The bounds basically rule out high Sharpe ratios - `good deals' - as well as arbitrage opportunities. We present the method of calculation, we extend it to a multiperiod context by finding a recursive solution, and we apply it to option pricing examples including the Black-Scholes setup with infrequent trading, and a model with stochastic stock volatility and a varying riskfree rate.

Date: 1996-03
Note: AP
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Published as Journal of Political Economy (February 2000 Revision of W5489, March 1996)

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