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| Pricing and Hedging in the Presence of Extraneous Risks by Pierre Collin-Dufresne of the University of California Berkeley, and October 16, 2006 Abstract: Given an underlying complete financial market, we study contingent claims whose payoffs may depend on the occurrence of non-market events. We first investigate the almost sure hedging of such claims. In particular, we obtain new representations of the hedging prices and provide necessary and sufficient conditions for a claim to be marketed. The analysis of various examples then leads us to investigate alternative pricing rules. We choose to embed the pricing problem into the agent's portfolio decision and study reservation prices. We establish the existence and consistency of this pricing rule in a semimartingale model. We characterize the non linear dependence of the reservation price with respect to both the agent's initial capital and the size of her position. The fair price arises as a limiting case. JEL Classification: G10, G11, G13, D81. Mathematics Subject Classification (2000): 60H30, 91B38, 93E20. Keywords: Non market risks, incomplete markets, utility based pricing, event risk, fair price. Forthcoming in: Stochastic Processes and their Applications. Previously titled: On the Pricing & Hedging of Contingent Claims in the Presence of Extraneous Risks Books Referenced in this Paper: (what is this?)
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