Pricing and Hedging Options in Incomplete Markets: Idiosyncratic Risk, Systematic Risk and Stochastic Volatility

Thierry Chauveau and Hayette Gatfaoui

No 122, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: Starting from the European option valuation framework of Chauveau and Gatfaoui (2002), we establish the link with stochastic volatility models. And, we propose both a new vision and a general framework for valuing European options in the light of systematic and idiosyncratic risks affecting risky assets in the financial market. Therefore, we account for the well-known volatility smile in the light of the literature addressing the determinants of the smile effect among which stochastic volatility and market risk. We further discuss briefly the hedging of European options along with the local risk minimization principle. Specifically, we attempt to find a strategy which dominates the usual partial hedging technique often imposed by market's incompleteness.

Keywords: call pricing; idiosyncratic risk; incomplete market; stochastic volatility; systematic risk (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2004-04-01
New Economics Papers: this item is included in nep-fin, nep-fmk and nep-rmg
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Working Paper: Pricing and Hedging Options in Incomplete Markets: Idiosyncratic Risk, Systematic Risk and Stochastic Volatility (2004)
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