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

Benedetti, Giuseppe and Campi, Luciano (2016) Utility indifference valuation for non-smooth payoffs with an application to power derivatives. Applied Mathematics and Optimization, 73 (2). pp. 349-389. ISSN 0095-4616

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Identification Number: 10.1007/s00245-015-9306-4

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

Item Type: Article
Official URL: http://link.springer.com/journal/245
Additional Information: © 2016 Springer Science & Business Media New York
Divisions: Statistics
Subjects: H Social Sciences > HA Statistics
H Social Sciences > HG Finance
Sets: Departments > Statistics
Date Deposited: 07 Aug 2015 11:41
Last Modified: 20 May 2019 01:59
URI: http://eprints.lse.ac.uk/id/eprint/63016

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