A Unifying Approach to Asset Pricing

Eckhard Platen ()

No 227, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: This paper introduces a general market modeling framework under which the Law of One Price no longer holds. A contingent claim can have in this setting several self-financing, replicating portfolios. The new Law of the Minimal Price identifies the lowest replicating price process for a given contingent claim. The proposed unifying asset pricing methodology is model independent and only requires the existence of a tradable numeraire portfolio, which turns out to be the growth optimal portfolio that maximizes expected logarithmic utility. By the Law of the Minimal Price the inverse of the numeraire portfolio becomes the stochastic discount factor. This allows pricing in extremely general settings and avoids the restrictive assumptions of risk neutral pricing. In several ways the numeraire portfolio is the “best” performing portfolio and cannot be outperformed by any other nonnegative portfolio. Several classical pricing rules are recovered under this unifying approach. The paper explains that pricing by classical no-arbitrage arguments is, in general, not unique and may lead to overpricing. In an example, a surprisingly low price of a zero coupon bond with extreme maturity illustrates one of the new effects that can be captured under the proposed benchmark approach, where the numeraire portfolio represents the benchmark.

Keywords: law of one price; law of the minimal price; benchmark approach; derivative pricing; numeraire portfolio; asset pricing; arbitrage (search for similar items in EconPapers)
JEL-codes: G10 G13 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2008-07-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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