Utility-Based Derivative Pricing

in Incomplete Markets
Jan Kallsen∗
Universität Freiburg i. Br.

Abstract

In recent years various suggestions concerning contingent claim valuation in incom-
plete markets have been made. We argue that some of them can be naturally interpreted
in terms of neutral derivative prices which occur if derivative demand and supply are
balanced. Secondly, we introduce the notion of consistent derivative pricing which is a
way of constructing market models that are consistent with initially observed derivative
quotations.

Keywords: fundamental theorem of utility maximization, local utility, neutral pric-
ing, consistent pricing

1 Introduction
Portfolio optimization, hedging, and derivative pricing constitute three fundamental quanti-
tative problems in mathematical finance. Since martingale methods have been introduced by
Harrison and Kreps (1979) and Harrison and Pliska (1981), these questions can be addressed
very elegantly in complete models. As the key tool they come up with the unique equivalent
martingale measure (EMM). Computing conditional expectations of some random variables
under this auxiliary measure yields important parts of the solution: the unique arbitrage-
free contingent claim value in the derivative pricing problem, the value of its replicating
portfolio in the hedging problem, and the optimal wealth process in utility maximization
problems (cf. Harrison and Pliska (1981), Pliska (1986), Karatzas et al. (1987), Cox and
Huang (1989)). An important early reference in this context is Bismut (1975).
In incomplete markets the situation is more involved because one is facing a mathemat-
ical and a conceptual problem: Mathematically, the use of martingale methods is compli-
cated by the fact that there exists more than one EMM. This may explain why they have

Institut für Mathematische Stochastik, Universität Freiburg, Eckerstraße 1, D-79104 Freiburg i. Br., Ger-
many, (e-mail: kallsen@stochastik.uni-freiburg.de). The author wants to thank Thomas Goll for fruitful dis-
cussions.

1

been applied only in the last decade. Nevertheless, martingale methods play a very impor-
tant role in incomplete models. In utility maximization problems, conditional expectations
still lead to the optimal wealth process if the right equivalent martingale measure is cho-
sen. Intuitively, this measure leads to an in some sense least favourable market completion
(cf. Foldes (1990, 1992), He & Pearson (1991a,b), Karatzas et al. (1991), Cvitanić and
Karatzas (1992), Pliska (1997), Kramkov and Schachermayer (1999), Cvitanić et al. (2001),
Schachermayer (2001b)).
As regards derivative pricing and hedging, we are facing the severe conceptual prob-
lem that unique arbitrage-free contingent claim values and perfect hedging strategies do
not exist. Derivative pricing in incomplete models basically means choosing one of the
set of equivalent martingale measures in some economically or mathematically motivated
fashion, e.g. based on hedging arguments (cf. Schäl (1994), Schweizer (1996)), on util-
ity or equilibrium-type considerations (cf. Davis (1997), Karatzas and Kou (1996), Frittelli
(1998), Rouge and El Karoui (2001), Bellini and Frittelli (2000), Kallsen (2001)), or on
distance minimization (cf. Keller (1997), Miyahara (1996, 1999), Chan (1999), Grandits
(1999a,b), Frittelli (2000), Goll and Rüschendorf (2001)). Similarly, various suggestions
have been made to replace the perfect hedge in complete models with a reasonable coun-
terpart in incomplete settings, e.g. based on hedging error minimization (cf. Föllmer &
Schweizer (1989, 1991), Schweizer (1991, 1992, 1994, 1995)), superhedging (cf. El Karoui
and Quenez (1995)), or utility maximization (cf. Föllmer and Leukert (2000), Kallsen (1998a,
1999), Cvitanić et al. (2001), Delbaen et al. (2000)).
Although the problems and even more so their solutions look quite different on first
glance, they are intimately related. The links between portfolio optimization, derivative
pricing, and hedging start to become folklore among experts. Still, the results are scattered
in the literature and have been derived in quite different settings. As far as derivative pricing
is concerned, some precise definitions are missing altogether. This makes it hard for the
non-specialist in the field to get an intuitive picture.
The aim of this paper is threefold. By focusing on one important result, we want to
provide the novice with an idea how martingale methods enter portfolio optimization in in-
complete models. Secondly, we give a precise definition of neutral derivative prices which
occur if traders maximize their expected utility and if supply and demand of derivatives are
balanced. Neutral prices are closely related to seemingly different concepts in the literature.
Thirdly, we introduce the notion of consistent derivative pricing which is a way of construct-
ing market models that are consistent with initially observed contingent claim quotations.
Previous approaches in this direction include inversion of the yield curve (cf. Björk (1997))
and Avellaneda et al. (1997), Avellaneda (1998), Kallsen (1998a,b), Goll and Rüschendorf
(2000). Since this paper aims at concepts rather than mathematical generality, we stick to a
finite market model.
The paper is organized as follows: The role of martingale methods in portfolio optimiza-
tion is reviewed in the subsequent section. Sections 3 and 4 deal with neutral and consistent
derivative pricing, respectively.

2

1 Let A denote an affine subspace of Rd and K := {ψ ∈ Rd : αj> ψ ≤ 0 for j = 1.e. In this paper. let A0 := A − a for some a ∈ A. Typical choices for the constraint sets (A. Your preferences are expressed in terms of a proper. there exists a unique predictable process (ϕ0t )t∈{0. . .1. We consider an investor (hereafter called “you”) who disposes of an initial endowment e ∈ R. . ϕd ). . Trading constraints are given in terms of subsets of the set of all trading strategies. . .. . functions like x 7→ x. . . . which are not differentiable on the boundary of their effective domain. . Moreover. . . predictable stochastic processes ϕ = (ϕ0 ... . . . . An > > > equivalent definition is ϕ S = ϕ0 S0 + ϕ · S.. .e. In the following. ϕdt )t∈{0.. . . Ω}. In order to avoid lengthy notation. A always denotes an affine subspace and K a polyhedral cone as in the previous definition. . . . i. . . . . H · Xt = ts=1 Hs ∆Xs . P A trading strategy ϕ is called self-financing if ∆ϕ> t St−1 = 0 for t = 1. we let F = P(Ω). T } we have (ϕ1t . . F0 = {∅. Proposition 1. . . . . Rd−1 × {0}) (fixed position ξ in security d). . where S 0 = 1. S d ). we identify S with the Rd -valued process (S 1 . ∞) which is differentiable on its effective domain (i. ({0. ϕdt )(ω) − a ∈ K. the notation H · X is used to denote the stochastic integral of H relative to X. . . and P ({ω}) > 0 for any ω ∈ Ω. securities 0. T } are finite... on √ {x ∈ R : u(x) > −∞}. K) we denote the set of all self-financing trading strategies ϕ with ϕ0 = 0 that satisfy the following condition: There exists an a ∈ A such that for any (ω. The transposed of a vector x is written as x> .K) are ({0}. If your trading strategy ϕ is self- financing with ϕ0 = 0. upper semi-continuous.2 Optimal trading 2.1. 0. 1. F.. . Rd+1 -valued discounted price process S = (S 0 . αq ∈ Rd . d whose prices are expressed in terms of multiples of the numeraire security 0. . Put differently. which make sense in continuous-time as well. . . . T . We write ∆Xt := Xt − Xt−1 for any stochastic process X. ϕd ) is self-financing and ϕ> 0 S0 = x (cf. . . d are modelled by their adapted. . ξ}. Moreover. q} a polyhedral cone. Trading strategies are modelled by Rd+1 -valued. Occasionally. T . Lamberton and Lapeyre (1996). . (Ft )t∈{0.T } such that ϕ := (ϕ0 . . where Ω and the time set {0. in fact. where ϕit denotes the number of shares of security i in your portfolio at time t. then the value of your portfolio is described by the discounted wealth process V (ϕ) defined as Vt (ϕ) := e + ϕ> · St for t = 0. By S(A. . . 0} × 3 . . . . We work with a filtered probability space (Ω. . where α1 . fit in our framework as well). . p and αj> ψ = 0 for j = p + 1.. P ). ({0. . Rd ) (no constraints). (R+ )d ) (no short sales).. . . we consider the following cases: Definition 2. . . We consider traded securities 0.. concave utility function u : R → [−∞. .3). .T } . . For any predictable process (ϕ1t . .T } and any x ∈ R. . .. which is just a sum in our simple setting. . ({0}. t) ∈ Ω × {1. . . . . Convention.1 General notation Our general mathematical framework for a finite frictionless market model is as follows. S d ).

We say that P ? : F → R is a signed probability measure with P - ? ? ? density dP if dP is a real-valued random variable with E( dP ) = 1 and P ? (C) = R dP ? dP dP ? dP ? C dP dP for any C ∈ F. K)-seperating measure if and only if ϕ> · S is a P ? -supermartingale for any ϕ ∈ S({0}. K)-arbitrage (resp. K) is called (A. cf.4 below). 2.. Schachermayer (1992).3 1.. arbitrage has to be replaced with no free lunch with vanishing risk (NFLVR) and EMM with sigma-martingale measure. We say that the market allows no (A. also Lemma 2. Harrison and Pliska (1981). The name seperating measure is taken from Kabanov (1997). ? 3. K)-seperating measure if it is a signed (A.2. A probability measure P ? ∼ P is an EMM if and only if S is a P ? -martingale.. Rogers (1994). We write EP ? (X|Ft ) := E(X dP dP |Ft )/E( dP dP |Ft ) for any dP ? real-valued random variable X if E( dP |Ft ) 6= 0. Any equivalent (resp. Kabanov and Kramkov (1994). Rd−1 × {0}) (Security d can only be traded once. K)-arbitrage if ϕ> · ST ≥ 0 P -almost surely and P (ϕ> · ST > 0) > 0. 4. In its definitive form in Delbaen and Schachermayer (1998). 4 . Delbaen & Schachermayer (1994. Remarks. namely at time 0. The following lemma is a simple form of the fundamental theorem of asset pricing which has been studied extensively (cf. A probability measure P ? ∼ P is called equivalent (A. 1. signed martingale measure (SMM)). (1990). An adapted process X is ? dP ? called P -(super)martingale if the process (E( dP |Ft )Xt )t∈{0.1 and 4. A signed probability measure P ? with P -density dP dP is called signed (A. Let P ? be a signed probability measure with density dPdP . arbitrage) if there is no such strategy. Definition 2. signed) ({0}. Harrison and Kreps (1979). K). These measures play an important role in the work of Delbaen & Schachermayer (1994. 1998). Willinger and Taqqu (1987).T } is a P -(super)mar- tingale. Theorems 4. and then has to be held till time T . K). ? 2. 5.R. A ({0}. K)-seperating measure. 1995. Schürger (1996). Definition 2. A similar statement holds for SMM’s. K)-seper- dP ? > ating measure if E( dP (ϕ · ST )) ≤ 0 for any ϕ ∈ S(A. 1998) on the fun- damental theorem of asset pricing (cf. Rd )-seperating measure is simply called equiva- lent martingale measure (EMM) (resp. in particular Pham and Touzi (1999). For arbitrary closed convex cones..2 A strategy ϕ ∈ S(A.). Rd )-arbitrage is simply called arbitrage. Note that P ? is a ({0}. Dalang et al. Jacod and Shiryaev (1998)). Kreps (1981).

K)} and show that the following two propositions hold. Here and in later proofs. equivalent (A0 .  2.39. K)) = { ki=1 αi L(ai ) ∈ P RΩ : α1 . ϕd . . K) = { ki=1 βi ai ∈ Rn : β1 . Rockafellar and Wets (1998). we do not discuss the consumption case in this paper (except for Remark 7 below). The general assertion follows almost literally as Theorem 1. . Ft. . . K) if it maximizes E(u(VT (ϕ))) = E(u(e + ϕ> · ST )) over all ϕ ∈ S(A. On the other hand. we denote by Ft. Since %> 0 = 0. Otherwise. r ∈ R such that %> c < r for any c ∈ C and %> b > r for any b ∈ B. 2. βk ≥ 0} P (cf. mt .Lemma 2. there exist a1 . K)-arbitrage) if and only if there exists an EMM (resp. Theorem 2. ak ∈ Rn such that S(A0 . This implies %>e c ∈ C.2 Utility of terminal wealth As an investor with given endowment e. They can be proved as follows. αk ≥ 0} is also a polyhedral cone and in particular closed and convex. 1. K) is optimal for terminal wealth under the con- straints (A.1 . . Therefore. Definition 2. K). we can identify the set of all self-financing strategies ϕ satisfying ϕ0 = 0 with Rn := Rm0 d × . . the mapping L : Rn → RΩ : ϕ 7→ ϕ> · ST is linear. 1. . . × RmT −1 d . .52). i = 1. .4 (Fundamental theorem of asset pricing) The market does not allow arbitrage (resp.5 We say that ϕ ∈ S(A. It remains to be shown that %> c ≤ 0 for any c ∈ C. it follows that S(A0 . K) corresponds to a polyhedral cone in Rn . . . it follows that r ≥ 0. then there exists some % ∈ RΩ such that %> c ≤ 0 for any c ∈ C and %> b > 0 for any b ∈ B. . there exists some c ∈ C with %> c > 0. By Rockafellar and Wets (1998). V is a closed convex cone.i . .3 below. . . . .mt the partition of Ω that generates Ft (for t = 0. . . (A0 . . you may want to choose your trading strategy in some optimal way. V = L(S(A0 . For K = Rd (no constraints) we call ϕ simply optimal for terminal wealth. . If C ⊂ RΩ is a closed convex cone and B ⊂ RΩ a compact convex set with C∩B = ∅. P ROOF.2. there exist % ∈ RΩ . Since a mapping is Ft -measurable if and only if it is constant on the sets Ft. Due to limited space. Theorem 3. Classical and intuitive suggestions are to maximize the expected utility from terminal wealth or consumption. 5 . K)- seperating measure). . . . A further related concept is introduced in Subsection 2.7 in Lamberton and Lapeyre (1996) for the unconstrained case if we set V := {ϕ> · ST ∈ RΩ : ϕ ∈ S(A0 . Hence. . 2. . which c > r for a positive multiple e yields a contradiction. . and since ϕ is uniquely determined by ϕ1 . As K and A0 are given by linear equality and inequality constraints. . . T ).

c(mT )). . we have κ = E(u0 (e + ϕ> · ST )) in this case. . In analogy to the fundamental theorem of asset pricing and to underline its importance. . .) P ROOF. and kω : Rn → R (for any ω ∈ Ω) by f (a. c) consisting of a ∈ Rd . . .l : Rn → R (for j = 1. any triple (a. Goll and Rüschendorf (2001). . Using this identification. . Kallsen (1998a. Moreover. . . Cox and Huang (1989).l and any real- valued random variable c.6 Let ϕ be a trading strategy in S(A. Al- though easier to prove. Schachermayer (2001b)).3. (1991). Karatzas et al. There exists a signed (A0 . Chapter 1c and the references therein). The extent to which the equivalence holds in more general settings depends sensitively on the chosen set of trading strategies and probability measures (cf. and a real-valued random variable c can be identified with an el- ement of Rn := (Rd × (Rm0 d × . . we denote by Ft. . . namely with (a. Therefore. βr ∈ Rd such that A = {a ∈ Rd : βi> (a − a0 ) = 0 for i = 1. Similarly. Lemma 2. K). Cvitanić et al. ψ. ψ ∈ S({0}. signed seperating measures. mT . T . K). . we set c(l) := c(ω) for l = 1. It is by no means new.t. . 2000b). . . . ψT (mT −1 ). Pliska (1997). mt−1 . ϕ is optimal for terminal wealth under the constraints (A. Foldes (1990. . hi : Rn → R (for i = 1. Kramkov and Schachermayer (1999). ω ∈ FT.mt the partition of Ω that generates Ft . . c) := E(−u(c)). Karatzas et al. the inclusion 2⇒1 is less often explicitly stated. l = 1. 2. . . ω ∈ Ft−1. Schachermayer (2001a) for an overview). . He & Pearson (1991a. . Rd ). . Ft. Cvitanić and Karatzas (1992). l = 1. r). . (2001). . t = 0. . mt−1 ). . a strat- egy ψ ∈ S({0}. ψ1 (1). . Theorem 9. t = 1.1 . . Versions can be found in Foldes (1990). We use the notation ψt (l) := (ψt1 (ω). . Write ϕ as ϕ = a + ψ with a ∈ A. . it plays a key role in many papers that apply martingale or duality methods to utility maximization (Pliska (1986). . we make the following weak technical Assumption. . we can define map- pings f : Rn → R ∪ {∞}. . . . . .4. . . . As in the proof of Lemma 2. . . (Of course. . there exist β1 . For the rest of this subsection. . 1⇒2: Let a0 ∈ A. . more gener- ally. 6 . q. . . Since A is an affine subspace of Rd . Especially the inclusion 1⇒2 can be traced way back to Arrow and Debreu (cf. Then we have equivalence between: 1. ψ. K) such that E(u0 (e + ϕ> · ST )) > 0. T . . . r}. . The following result characterizes optimal strategies in terms of EMM’s or. Goll and Kallsen (2000). T . we daringly call it a fundamental theorem of utility maximiza- tion. Duffie (1992). .b). (1987). K)-seperating measure P ? and a number κ such that ? (a) κ dP dP = u0 (e + ϕ> · ST ). . (1991). c(1). .l . (b) ψ > · S is a P ? -martingale. . 1992). K) such that VT (χ) = e + χ> · ST has only values in the interior of the effective domain of u. gj. × RmT −1 d ) × RmT ) and vice versa. There exists a strategy χ ∈ S(A. Karatzas et al. . ψtd (ω)) for t = 1.

T .t. kω = 0 (for any ω ∈ Ω).2 and 28. Then Statement 2 in Lemma 2. (b) 0 = qj=1 µejt αj − E(%∆St |Ft−1 ) for t = 1. . ψtd ) = 0 for j = 1. . 2⇒1: Similarly as in the first part of the proof. one shows that a random variable c ? minimizes E(−u(c)) under the constraint E( dP dP (c − e − aT (ST − S0 ))) ≤ 0 if there exists a non-negative real number κ such that we have ? 1.l ejt (ω) := µj. νi (for i = 1. . νi can be chosen independently of (a. .l = 0 (for j = p + 1. . With this notion. . . t = 1. Theorems 28. κE( dP dP (c − e − a> (ST − S0 ))) = 0. . P P Pm 2. (a) 0 = −u0 (c) + %. . E( dP dP (c − e − a> (ST − S0 ))) ≤ 0. c) + ri=1 νi ∇hi (a. hi = 0 (for i = 1. . . K) if and only if there exists a real-valued random variable λ and real numbers µj. . .t. P (c) 0 = ri=1 νi βi − E(%(ST − S0 )). ψ. . Replacing λ(ω) with %(ω) := λ(ω)/P ({ω}) as well as µj. r) such that we have for c := e + (a + ψ)> · ST : 1. . T . . µj.3 it follows that a + ψ is optimal for terminal wealth under the constraints (A.l (a. c) + qj=1 Tt=1 l=1t−1 µj. . ψ. . . . kω (a. r).l ∇gj. . From Rockafellar (1970). . . gj. mt−1 ). . a vector ν = (ν1 . ψ. p. ψ. 7 . . . ? 3. c). where ∇ denotes the gradient of a mapping Rn → R. . p. .l (a. ψ.l ) and straightforward calculations yield the with µ following equivalence: a + ψ is optimal for terminal wealth under the constraints (A. a + ψ is optimal for terminal wealth under the constraints (A. . t = 1. . µ ejt αj> (ψt1 . . T . ψ.l /P (Ft−1. . . T . . p. . . K) if and only if (a. q.t.l ≥ 0 and µj. . . νr ) ∈ Rr . 0 = ∇f (a. . and a predictable Rq -valued process µ e such that we have for c := e + (a + ψ)> · ST : ejt ≥ 0 and µ 1. mt−1 . . ? 2. l = 1. . P Suppose now that ϕ = a+ψ is optimal for terminal wealth under the constraints (A. . 0 = −u0 (c) + κ dP dP . . K). .t. t = 1. . mt−1 ). t = 1. . K) if and only if there exists a real-valued random variable %. . . .l (for j = 1. t = 1. ψ.l . ? Let κ := E(%) = E(u0 (e + ϕ> · ST )) and dP dP := κ% . T . . . . Note that λ. q. c). l = 1. . c) := βi> (a − a0 ). . . . T .t. .t. . gj.t.t. . .t. 2. . . . c) := c(ω) − e − (a + ψ)> · ST (ω). l = 1. c) + P P ω∈Ω λ(ω)∇kω (a. hi (a. . .l ) (for ω ∈ Ft−1.6 holds. . . . µj. . c) := αj> ψt (l).t. . . . Note that all these are convex mappings on Rn . ψ. l = 1.l ≤ 0 (for j = 1. . ψ. . e + (a + ψ)> · ST ) minimizes f subject to the constraints gj.l αj> ψt (l) = 0 for j = 1.t. . . mt−1 ).

K)-seperating measure.g. one has to replace the derivative u0 in Lemma 2.) Definition 2. K)-seperating measure. the (A.8 We call the measure P ? in Lemma 2. Moreover.6 with the subdifferential of u (cf. ϕ 2. . (2000). . K). If the utility function is not differ- entiable. Therefore. If K is a subspace of Rd .. 1995). . ∞) such that dP dP = κ1 u0 (e+ϕ> ·ST ) for some equivalent martingale measure P ? . Rd−1 × {0}). Observe that ϕ0 does not affect the stochastic integral ϕ> · S in Definition 2. Statement 2b follows from the fact that P ? is a (A0 . let ϕ be a self-financing trading strategy.6 is in fact an equivalent (A0 . (Of course.5 also allows to address hedging problems. Föllmer and Leukert (2000). then P ? in Lemma 2. d − 1. . the respective proof). Kallsen (1998a)). ξ}. But note that e e · ST = ( ϕ c := e + ϕ e − a) · ST + e + a (ST − S0 ) dP ? > c − e − a (ST − S0 ))) ≤ 0 for any ϕ satisfies the constraint E( dP (e e ∈ S(A. Delbaen et al. Then we have equivalence between: 1. K)-dual measure for terminal wealth. K) appropriately.7 (Fundamental theorem of utility maximization) Let u be strictly increas- ing on its effective domain.. . then any e have the same wealth process e + ϕ> · S. 5. Remarks. K)-dual measure for terminal wealth is unique. There exists a number κ ∈ (0. K)-seperating measure. we have κ = E(u0 (e + ϕ> · ST )) in this case. Moreover. 4. then it suffices to assume that E(u0 (e + ϕ> · ST )) 6= 0 (instead of > 0) in Lemma 2. . 8 . If there is more than one optimal solution ϕ. A rea- sonable suggestion is to choose an optimal strategy in S({0. . Definition 2. K) because P ? is a S(A0 .. If u is strictly concave. which implies that ϕ is optimal for terminal wealth under the constraints (A. 0.6 (A.6. ? It follows that c := e + ϕ> · ST minimizes E(−u(c)) under the constraint E( dP dP (c − e − > > > > a (ST − S0 ))) ≤ 0. If u is strictly increasing on its effective domain. .  Corollary 2.6 can be cho- sen independently of the particular solution (cf. . . 1. . By choosing the constraint sets (A. in Schweizer (1994. then P ? in Lemma 2. 3. Therefore E(u(e + ϕ> · ST )) ≥ E(u(e + ϕ e> · ST )) for any ϕe ∈ S(A.T } without any self-financiability constraint and choose ϕ0 such that ϕ is indeed self-financing. ? 2. K). ϕ is optimal for terminal wealth. two optimal solutions ϕ.5. Suppose you have a fixed number ξ of shares of security d and you want to hedge the resulting risk by trading in securities 0. This utility-based approach to hedging has been taken e. ϕdt )t∈{1. You only need to consider (ϕ1t . ..

ϕdt (ω)) for t = 1. Section 19). Rd ) with an element of Rn := (Rm0 d × . . then ϕ> · ST = 0 because there is no (A0 . In this case f is constant in direction ϕ. 0 (x ) Step 3: W. . . . Similarly. the fundamental theorem of utility maximization does not lead to explicit solutions in general. u(0) = 0. Theo- rem 27. K) if it minimizes f on C. .g. the utility P function may depend on t ∈ {0. Kallsen (2000)). . Schachermayer (2001a). T . Kallsen (1998a)). which implies −f (λϕ) = E(u(λϕ> · ST )) → −∞ for λ → ∞. c) is optimal if and only if there exists a number κ ∈ ? (0. If ϕ> · ST ≥ 0. Lemma 2. . Therefore. Therefore. then an optimal strategy ϕ for terminal wealth under the constraints (A. Then ϕ corresponds to a strategy in S(A0 . then the optimal payoff is ? obtained as e + ϕ> · ST = (u0 )−1 (κ dP dP ). .l . Hence we may assume P (ϕ> · ST < 0) > 0. If there is no (A0 . This is the case in complete models and it gives rise to the martingale method in portfolio optimization (cf. In this sense S(A. Here. The corresponding version of Corollary 2. Note that u(λx) λ ≤ u0 (x1 )x + O( λ1 ) for x > 0 and λ → ∞. . K) exists.o. Let ε > 0 and choose x2 < 0 < x1 such that uu0 (x 1 2) < ε. Rockafellar (1970). Then ϕ is optimal for terminal wealth under the constraints (A. mT −1 . . . l = 1. . we identify any trading strat- egy ϕ ∈ S({0}. T } (cf. 6. If the “right” P ? is known and if u is strictly concave.  For more general versions of this lemma cf. For small ε we have εE((ϕ> · ST )+ ) + E(−(ϕ> · ST )− ) < 0. . In general. K)-arbitrage. . e = 0.3 f attains its minimum on C if f is constant on the common directions of recession of f and C. . Therefore ϕ cannot be a direction of recession of f . . Step 2: Let ϕ be a direction of recession of f and C. it is not evident how to find an EMM whose density is related in this way to the terminal payoff of some trading strategy. T }. K).4. Define the convex function f : Rn → R. . ϕ 7→ −E(u(e + ϕ> · ST )). which implies that ϕ cannot be a direction of recession of f . it is very useful in order to verify that some given candidate is indeed optimal (cf.7 then reads as follows: (ϕ. 7. 9 . Goll and Kallsen (2000). × RmT −1 d ) via ϕt (l) := (ϕ1t (ω). . u(λx) λ ≤ u0 (x2 )x + O( λ1 ) for x < 0 and λ → ∞.l. . By Rockafellar (1970). K) corresponds to a polyhedral subset C of Rn (cf.9 Suppose that u is increasing and for any ε > 0 there exist x1 > x2 with u0 (x1 ) u0 (x2 ) < ε. Nevertheless. . Korn (1997) for an introduction). Note that u must be finite on R: Otherwise f (λϕ) = −E(u(e + λϕ> · ST )) = ∞ for λ ∈ R+ large enough. In utility maximization problems with consumption one usually tries to maximize E( Tt=0 ut (ct )) over all pairs of self-financing trading strategies ϕ and consumption P plans c satisfying the financiability constraint Tt=0 ct ≤ e + ϕ> · ST . Step 1: Similarly as in the proof of Lemma 2. P ROOF. lim supλ→∞ λ1 E(u(λ(ϕ> · ST )+ )) ≤ εu0 (x2 )E((ϕ> · ST )+ ) and lim supλ→∞ λ1 E(u(−λ(ϕ> · ST )− )) ≤ u0 (x2 )E(−(ϕ> · ST )− ). . ω ∈ Ft−1. . K)-arbitrage. ∞) and an equivalent martingale measure P ? such that E( dP dP |Ft ) = κ1 u0t (ct ) for t ∈ {0.

. Definition 2. . Observe that Definition 2. the remark following Definition 2. In order to state the analogue of Lemma 2. You do not care about past profits and losses or your exact current wealth. . As in the previous subsection. If E( dP dP |Ft ) 6= 0 P -almost surely for t = 0. T .2. . .3 Local utility Especially in hedging applications it may be very hard to compute optimal portfolios ex- plicitly because one has to deal with constraints resp. say. K). then the logarithm process of P ? is unique and E(1 + ∆Nt |Ft−1 ) = 1 for t = 1. T . but here financial gains are consumed immediately (cf. day-by-day basis. K) is locally optimal under the con- straints ({a}. . If you are a local utility maximizer. Remarks. ? 2. This makes it much easier to obtain explicit solutions than in the terminal wealth case. . Kallsen and Shiryaev (2000). . this means that optimal portfolios can be computed seperately for any one-period step. . The notion of local utility has been introduced in Kallsen (1998b. The concept is related to maximization of consumption. K) such that u0 (ϕ>t ∆St ) > 0 P - almost surely for t = 1. . T } (not only for t = T ). where (N ) = ·t=1 (1 + Q ∆Nt ) denotes the stochastic exponential of N . . K) if it maximizes E( Tt=1 u(∆Vt (ϕ))) = E( Tt=1 u(ϕ> P P t ∆St )) over all d ϕ ∈ S({a}. Remark. c0 = 0 (cf. . we make a weak technical Assumption. . . In this subsection. . 1. Remark 4 at the end of this section).10 We say that a strategy ϕ ∈ S({a}. A way out is to work instead with the simpler concept of local utility maximization. . . but the concept of step-by-step opti- mization goes at least back to Föllmer and Schweizer (1989) (cf. . we need the following ? Definition 2.11 We say that a signed probability measure P ? with P -density dP has loga- dP Q dP ? rithm process N if N is an adapted process with N0 = 0 such that E( dP |Ft ) = ts=1 (1 + ∆Ns ) for t = 1. Then we have equivalence between 10 . K) such that χ> t ∆St . The name is motivated by the fact that dPdP ? = E E (N )T . There exists a strategy χ ∈ S({a}. T . Kallsen (1999). .6. Mathemati- cally. T . Remark 7 above) if we require in addition that Pt > s=1 cs = ϕ · St for any t ∈ {1. . random endowment. . . you try to do your best on a. 1999). . For a continuous-time extension of this approach cf. .10). Theorem 2. t = 1.12 Let ϕ be a trading strategy in S({a}.10 corresponds to an optimal investment with con- sumption problem for e = 0. we assume throughout that A = {a} for some a ∈ Rd . For K = R (no constraints) we simply call ϕ locally optimal. T has only values in the interior of the effective domain of u. For details on stochastic logarithms in continuous-time cf.

. . T . gj. Rd ) and an adapted real-valued process c can be identified with an element of Rn := ((Rm0 d ×. T . ϕ is locally optimal under the constraints ({a}. . T . c) := E − u(ct ) . l = 1. T . . . .l /P (Ft.mt the partition of Ω that generates Ft . l = 1. l = 1. . mt−1 ). .l ) as well as ejt (ω) := µj.1 . T . . Theorems 28. . any pair (ϕ. mt ) by  T X  f (ϕ. t = 1. K) if and only if (ϕ. ϕdt (ω)) for t = 1.. K) is locally optimal under the constraints ({a}.t. Using this identification. From Rockafellar (1970). . .×RmT )) and vice versa. . P P Pm 2. t = 1. . . . . . . . . we can define mappings f : Rn → R∪{∞}. p.t. . . T . . l = 1.l . l = 1. . .t. . q. t = 1. . . . µj. . .3 it follows that ϕ ∈ S({a}. mt ) and real numbers µj..l = 0 (for j = p + 1. mt−1 ). ω ∈ Ft. T .t. . . kt. . q. .l ∇gj. .l with µ the following equivalence: ϕ is locally optimal for terminal wealth under the constraints ({a}.l ∇kt. l = 1. . mt−1 ) such that we have for c := ϕ> ∆S: 1.×RmT −1 d )×(Rm1 ×. . Replacing λt.t. K)-seperating measure P ? with logarithm process N and a predictable process κ such that (a) κt (1 + ∆Nt ) = u0 (ϕ> t ∆St ) for t = 1. With this notion. mt−1 . . . c) := ct (l) − ϕt (ω)> ∆St (ω) for an arbitrary ω ∈ Ft.t.l (ϕ. 1.l can be chosen independently of (ϕ. . .l (for t = 1. 1⇒2: As in the proof of Lemma 2. .t. . . (Obviously. T . . c1 (1).l . . and any adapted real-valued process c. . . T . . .6. . . . we denote by Ft. . mt . K) if and only if there exist real numbers λt.l ≤ 0 (for j = 1.l ) (for ω ∈ Ft.t. t=1 > gj. . . ϕ is locally optimal under the constraints ({a}. . .l (ϕ. Ft. . t = 1. .. we write ct (l) := ct (ω) for t = 1. . l = 1. . mt−1 . p. l = 1.t. Similarly.l (for j = 1. . . . c). . . K). K) if and only if there exists an adapted real-valued process % and a predictable Rq - valued process µ e such that we have for c := ϕ> ∆S: 11 . . . . .l (ϕ. . 0 = ∇f (ϕ.. . . There exists a signed ({0}. .l . c). . kt. c) + qj=1 Tt=1 l=1t−1 µj. . 2. Note that λt. . Note that all these are convex mappings on Rn . . (ϕ> t ∆St )t∈{1. . . . . mt ).l ) and straightforward calculations yield µj. . . . T .l ≥ 0 and µj. gj. . c) + Tt=1 m P P t l=1 λt.l = 0 (for t = 1.l /P (Ft−1. . (b) (ϕ − a)> · S is a P ? -martingale. . . . . .t. µj. t = 1. . c) consisting of a strategy ϕ ∈ S({a}. . . q. namely with (ϕ1 (1). .l with %t (ω) := λt. . . . .l : Rn → R (for j = 1. .l .t. . Therefore. . . . t = 0. l = 1. c) := αj (ϕt (l) − a). ω ∈ Ft−1. . .) P ROOF. . ϕT (mT −1 ). . . . .l αj> ϕt (l) = 0 for j = 1. .l (ϕ. cT (mT )).T } ) minimizes f subject to the constraints gj. . l = 1. .2 and 28. . . . kt. mt−1 ). . where ∇ denotes the gradient of a mapping Rn → R.l ) (for ω ∈ Ft−1.l : Rn → R (for t = 1.t. . . . . T and we use the notation ϕt (l) := (ϕ1t (ω). . we have κt = E(u0 (ϕ> t ∆St )|Ft−1 ) in this case. . T .

. ejt ≥ 0 and µ 1. . K)-seperating measure. . E((1 + ∆Nt )(ct − a> ∆St )|Ft−1 ) ≤ 0. (a+K)-valued random vectors ϕt seperately for any t ∈ {1. 12 .15 below).12 holds. Finally. It follows that c := ϕ> ∆S minimizes E(− Tt=1 u(ct )) under the con- P straints E((1 + ∆Nt )(ct − a> ∆St )|Ft−1 ) ≤ 0 for t = 1. 2.  Definition 2. . . . . 2. i. T ) if there exists a non-negative predictable process κ such that we have 1. .9 below (in the case n = 1) as an optimal hedge. T . . . 2. p. . K). 0. µ ejt αj> (ϕ1t . K)-dual measure for local utility. . constraint set S({0. which implies that ϕ is locally optimal under the constraints ({a}. . local utility maximization practically means maximization of E(u(ϕ> t ∆St )) over all Ft−1 -measurable. Rm × {0}) and S m+1 as security m + 1. . T . . . . κt E((1 + ∆Nt )(ct − a> ∆St )|Ft−1 ) = 0. they pro- pose the trading strategy ψ appearing in Definition 3. . . Remarks. . . 2⇒1: Similarly as in the first part of the proof. . 0 = −u0 (ct ) + κt (1 + ∆Nt ) for t = 1. 1. (a) 0 = −u0 (ct ) + %t for t = 1. Then Statement 2 in Theorem 2. . t = 1. ϕ can be chosen independently for t = 1. T . . T . Remarks 1–3 from Subsection 2.2 hold accordingly. 4. In the local utility optimization problem. . T . The approach of Föllmer and Schweizer (1989) to option hedging in incomplete mar- kets is based on one-period hedging error minimization. . Therefore. then it suffices to assume that u0 (ϕ> 0 > t ∆St ) 6= 0 and E(u (ϕt ∆St )|Ft−1 ) 6= 0 P -almost surely for t = 1. . . . t = 1. . Therefore E( t=1 u(ϕt ∆St )) ≥ E( Tt=1 u(ϕ e> P t ∆St )) for any ϕe ∈ S({a}. . .e. . . . . . . 1}. Define κt := %t E(%t |Ft−1 ) = E(u0 (ϕ> t ∆St )|Ft−1 ) and ∆Nt := κt − 1 for t = 1. 3. . . T . K). K) because P is a S({0}. More specifically.13 We call the measure P ? in the previous theorem ({a}. . . . . ϕdt ) = 0 for j = 1. . P Suppose now that ϕ is locally optimal under the constraints ({a}. . one shows that an adapted process c minimizes E(− Tt=1 u(ct )) under the constraints E((1 + ∆Nt )(ct − a> ∆St )|Ft−1 ) ≤ 0 P (for t = 1. . . also Lemma 2. . K)-seperating measure. If K is a subspace of Rd . But note that e c := ϕe> ∆S satisfies the constraints E((1 + ∆Nt )(e ct − a> ∆St )|Ft−1 ) ≤ 0. . T for any ϕ e∈ ? PT > S({a}. . maximization of the utility of discounted one-period gains (cf. . . T }. T . (b) 0 = qj=1 µ ejt αj − E(%t ∆St |Ft−1 ) for t = 1.10 and the previous remark shows that this ψ is locally optimal for the utility function u(x) := −x2 . set P· N := t=1 ∆Nt and dP dP ? E := (N )T . Statement 2b follows from the fact that P is a ({0}. . More- ? over. . 3. T (instead of u0 (ϕ> t ∆St ) > 0). K). A comparison with Definition 2. .

distance minimization and L2 -approximation pricing often lead to the same prices. d}. From the market clearing condition and from standard variation arguments it follows that the discounted price process of any traded security in this economy must be a 13 . . . . . The statement follows along the same lines as the proof of Lemma 2. ϕdt (ω)) for t = 1. . . If there is no ({0}. . . . . mt−1 . hedging problems can be addressed by considering appropriate constraint sets (cf. . K) if and only if E(u0 (ϕ> t ∆St ) i ∆St |Ft−1 ) = 0 for i = 1. mt−1 .l . . . . (1999)). . This is the case if and only if 0 = ∇i ft. . . . . . T .  Lemma 2. . Kallsen (1999)). . . Then ϕ ∈ S({a}. . Eberlein and Jacod (1997). 5. As in the terminal wealth case. it suffices to assume absence of arbitrage in order to obtain unique prices. Even in many models of practi- cal importance arbitrage arguments yield only trivial bounds on contingent claim prices (cf. . Then ϕ ∈ S({a}. Moreover.l . we identify any trading strategy ϕ ∈ S({0}. The situation is less obvious in incomplete markets. Derivative pricing in complete models is well understood. . Rd ) with an element of Rn := (Rm0 d × . . .15 Suppose that K = Rk × {0} ⊂ Rd for some k ∈ {0. . Lemma 2. then a locally optimal strategy ϕ under the constraints ({a}. .l : Rd → R subject to the constraint ϕt (l) ∈ {a} + K seperately for t = 1. P ROOF. Unique values can only be derived under stronger assumptions.  3 Neutral derivative pricing In this section we turn to derivative pricing. we will see that other valuation approaches as e. Define ft.l (ϕt (l)) = −E(u0 (ϕ> i t ∆St )∆St |Ft−1 )(ω) for i = 1. .g. . K) is locally optimal under the constraints ({a}. × RmT −1 d ) via ϕt (l) := (ϕ1t (ω). . Cvitanić et al.l . l = 1.5. mT −1 . . Sometimes it is suggested to apply some kind of equilibrium asset pricing based on production and the preference structure of agents in the economy. . . More exactly.l (ϕt (l)) := −E(u(ϕ> t ∆St )| Ft−1 )(ω) for t = 1. . l = 1.14 Suppose that u is increasing and for any ε > 0 there exist x1 > x2 with u0 (x1 ) u0 (x2 ) < ε. k and t = 1. .9. K) is locally optimal under the constraints ({a}. T . T . . Similarly as in the proof of Lemma 2. . Later. 1. . . . P ROOF. . . . we propose a way to extend a market model for the underlyings to a model for both underlyings and derivatives. . . ω ∈ Ft−1. assume that they all dispose of a random aggregate endowment eT up to time T . . . T . . l = 1. As an example let us consider a market consisting of a number of identical investors (or a representative agent as a stand-in) who all maximize their expected utility of terminal wealth in the sense of Definition 2. . Frey and Sin (1999). Since contingent claims are redundant securities.9. K)-arbitrage. K) if and only if ϕt (l) minimizes ft. T . . ω ∈ Ft−1. . T . K) exists. k and t = 1. Note that ϕ maximizes ϕ 7→ E( Tt=1 u(ϕ> P t ∆St )) if and only if ϕt maximizes > ϕt 7→ E(u(ϕt ∆St )) =: −ft (ϕt ) seperately for t = 1. where ω ∈ Ft−1.

u0 (eT ) one may be tempted to just guess some eT such that E(u 0 (e )) is the density of an EMM. ? martingale with respect to some probability measure P ? whose density dP dP is a multiple of 0 u (eT ) where u denotes the utility function of the investors. Of course. Hence we can compute prices for any asset whose terminal payoff at time T is given. this reasoning can and has been modified. and refined in many ways. We only want to stress two important features: On the one hand.5 with fixed non-random endowment e ∈ R. we assume that only some identical investors trade in derivatives as well. they may turn out not to be P ? -martingales. the degree of arbitrariness is greatly reduced. neutral price processes still depend on the preferences and the initial endowment of the derivative traders. (This assumption will be relaxed in the next section. Since the endowment is not observable. 14 . Put differently. Note that we certainly have to consider random endowment in this case. Note that we no longer need to consider a random endowment eT to reproduce underlying prices because the clearing condition applies only to contingent claims. Note that we run into a consistency problem if we want to apply this concept naively to derivative pricing. we do not recover the right price even for trivial contingent claims whose payoff at maturity equals the underlying. they are stable in the sense that they do not lead to unmatched supply or demand of derivatives. We want to suggest an alternative that mediates between derivative pricing in complete models and general equilibrium asset pricing. Since the underlying price processes that are given in the first place are not incorporated in this approach. The idea is to apply the equilibrium arguments only to the secondary market.) Suppose that these investors are expected utility maximizers as in Definition 2. A problem with this approach is its arbitrariness. by letting eT := (u ) ( dP ) one can obtain any equivalent martingale measure P ? in this fashion. By contrast. In view of the fundamental theorem of asset pricing we obtain a price system that is consistent with absence of arbitrage. generalized. T 0 −1 dP ? However. this is not a genuine derivative pricing approach. This means that any derivative price in the no-arbitrage interval can be recovered by choosing eT appropriately. On the other hand. A way out is to choose the exogenous endowment eT such that P ? is in fact a martingale measure for the given underlyings. Therefore the use of this approach to derivative pricing is limited unless one has good reason to assume a specific kind of endowment.1 below. we obtain prices for any security with given payoff at time T . On the other hand. Of course. We take the underlying price processes as given ignoring the market mechanisms they result from. Since any derivative that is bought has to be sold and since the derivative traders behave identically. Intuitively. we end up with the following market clearing condition: Derivative prices should be such that the optimal portfolio of the representative investor contains no contingent claim. Such prices are termed neutral in Definition 3. However. not only the preferences but also the random endowment of the representative agent has to be given exogenously as input. Otherwise P ? = P which is generally no EMM.

S m+n neutral derivative price processes for terminal wealth if there exists a strategy ϕ in the extended market S 0. . . Theorem 3. . S m+n derivative price processes if STm+i = Rm+i for i = 1. . n. . . the only in- formation on the derivatives is their discounted terminal payoffs Rm+1 . . . . T . for simplicity we stick to the above version. (1991) in the context of portfolio optimization. . m + n. . . For reasons that will become clear below. S m such that E(u0 (e + ϕ> · ST )|Ft ) 6= 0 P -almost surely for t = 0. T (cf. T . 3. . . . . n. i = 1. . . . . a portfolio containing no derivative is optimal. 0). . P ROOF. However.b). Recall that P ? is an EMM if u is strictly increasing on its effective domain. which are supposed to be FT -measurable random variables. . also Karatzas and Kou (1996)). They are given by Stm+i = EP ? (Rm+i |Ft ) for t = 0. The first to notice the duality between portfolio optimization and least favourable market completion seem to be He and Pearson (1991a.1 Terminal wealth Fix a utility function u and an initial endowment e ∈ R such that e belongs to the interior of the effective domain of u. We call adapted processes S m+1 . . . . Let Stm+i = EP ? (Rm+i |Ft ) for t = 0. S m+n which is optimal for terminal wealth (without constraints. we can produce almost no reference where such an approach has been taken. Rm+n ) in the extended market by ϕ := (ϕ. n and define a trading strategy ϕ ∈ S({0}. = ϕm+n = 0. . . . . . we assume that there exists an optimal strategy for terminal wealth ϕ in the underlyings’ market S 0 . The underlyings are given in terms of their discounted price process S = (S 0 . . . . . . . the first to suggest this kind of valuation seems to be Davis (1997) (cf. Nev- ertheless. Definition 3. . . . we call the unique ({0}. . for ({0}. S m+n is not higher than in the market S 0 . . Lemma 2. Rm )-dual measure for terminal wealth P ? neutral pricing measure for terminal wealth. . Davis’ suggestion for a reasonable derivative price is such that among all strategies that buy an infinitesimal number of contingent claims and hold it till maturity. Although he does not claim that this remains true if we compare among all portfolios trading arbitrarily with the contingent claim. . . this valuation principle may sound quite natural or even familiar.e. .1 We call derivative price processes S m+1 . . A slightly more general definition that avoids claiming the existence of an optimal strategy could be based on the property that the maximal expected utility in the market S 0 . . .6 yields that 15 . . S m . . . For the following. (1991). The general setting is as in the previous section. . In fact. S m ). . .9). m and derivatives m + 1. . . Rm+n )) and satisfies ϕm+1 = .b) and Karatzas et al. To an economist. . this follows in an Itô- process setting from duality results by He and Pearson (1991b) and Karatzas et al. . . Lemma 2. . Rm+n at time T . . . i = 1. . We distinguish two kinds of securi- ties: underlyings 0. . At this stage. . i.2 There exist unique neutral derivative price processes. but the corresponding price system has been considered before by He and Pearson (1991a. .

S m+n . .6 it is shown that for Q = P ? the supremum is attained in c = e + ϕ> · ST . S m+n be neutral derivative price processes and ϕ ∈ S({0}. ψ := (ϕ0 . we have u0 (ϕ> · ST ) = u0 (ψ > · ST ) and hence u0 ((ϕ. . Note that sup{E(u(e + X − EQ (X))) : X FT -measurable random variable} = sup{E(u(c)) : c FT -measurable random variable with EQ (c − e) = 0}. . In particular.1) Investing in the underlyings does not increase your utility because you can buy the terminal payoff ϕ> · ST of any strategy ϕ as a contingent claim at time 0. . Conversely. . It corresponds to the market completion that is least favourable to you as an investor. S m+n are P ? -martingales. Keller (1997). . which yields the uniqueness. . .ϕ is optimal for terminal wealth. let S m+1 . (3. Grandits (1999a. . Chan (1999). . . . . ϕm ) ∈ S({0}. Lemma 3. S m+n if u is strictly increasing on its effective domain. Goll & Rüschen- dorf (2001)). Obviously. 0) ∈ S({0}. . . S m .  Note that P ? is an EMM for the extended market S 0 . . Similarly as in the second part of the proof of Lemma 2. . . It has been studied in the context of derivative pricing by Bellini and Frittelli (2000). the corresponding price system allows no arbitrage. which in turn implies that S m+1 . Rm ) is an optimal strategy for terminal wealth in the market S 0 . In particular. . If an EMM Q is interpreted as a pricing rule.3 (Least favourable market completion) If u is strictly increasing on its effec- tive domain. . However. 1999). then it induces a market completion: In the completed market any FT -measurable claim is traded at time 0 at a price EQ (X). . . . Rm+n ) a corresponding optimal strategy for terminal wealth. . . then the neutral pricing measure P ? minimizes sup{E(u(e + X − EQ (X))) : X FT -measurable random variable} over all equivalent martingale measures Q. Since EQ (ϕ> · ST ) = 0 for any EMM Q. The following result shows that this measure leads to neutral derivative prices. . From Lemma 2. S m+n are neutral derivative price processes.b). Miyahara (1996. The minimax martingale measure P ? is defined as the measure which minimizes the expression (3. One may critisize that distance minimization is a purely mathematically moti- vated criterion which is hard to interpret economically. the claim follows.1) (cf.6 it fol- lows that S m+1 . Your optimal expected utility in this completed market obviously equals sup{E(u(X)) : X FT -measurable random variable with EQ (X) = e} = sup{E(u(e + X − EQ (X))) : X FT -measurable random variable}. the relative entropy and the Hellinger distance or more generally Lp -distances have been considered (cf. He and Pearson (1991b)). where ϕ denotes the optimal strategy for terminal wealth. P ROOF. . Frittelli (2000). . (ϕ. Since ϕ is an optimal strategy in this market as well. . . In particular. S m+n )) = u0 (ϕ> · (S 0 . . . Rm+n ) is an optimal strategy in the market S 0 .  Some authors suggest to choose an EMM P ? as a pricing rule that is closest in some sense to the original probability measure P . S m+n )). 0)> · (S 0 . Bellini and Frittelli (2000) 16 . . . . .

For f (x) = exp(e + x) we have f ∗ (x) = | xb |(log | xb | − 1 + eb) for x < 0. c ∈ R and any x ∈ [−b. c ∈ R and any x ∈ (−b. 3. 0). P ROOF. W. i.e. then p the neutral pricing measure minimizes E(( dQdP ) p−1 ) over all equivalent martingale measures Q. and any x ∈ R.e. a > 0. Section 12). also Goll and Rüschendorf (2001) in this con- text). If u(x) = −a|x+b|p +c for some p ∈ (1. 2.  Mean-variance hedging tries to approximate contingent claims as close as possible in an L2 -sense by the payoff of some portfolio with initial investment y ∈ R and trading 17 . 5. Statements 2–5 are shown similarly. a > 0. ∞).∞) dP where f ∗ denotes the convex conjugate of f (cf. b > 0. the entropy of P relative to Q.∞) E(f ∗ (−κ dQ dP )) = inf κ∈(0. b. p then the neutral pricing measure minimizes −E(( dQ dP ) p−1 ) over all equivalent martin- gale measures Q. a > 0. i. Therefore inf κ∈(0.3.g. b. then the p neutral pricing measure minimizes E(| dQ dP | p−1 ) over all signed martingale measures Q. If u(x) = a log(x + b) + c for some a > 0. If u(x) = −a(x+b)p +c for some p ∈ (−∞. a = 1.l. Note that this expression gets minimal in Q if and only if EQ (log( dQ dP )) gets minimal. then the neutral pricing measure minimizes EQ (log dQ dP )) over all equivalent martingale measures Q.∞) κ(EQ (log( dQ dP ) + log(κ) − 1 + eb). 1). In view of Lemma 3. Set f (x) := −u(e + x) and let Q be an EMM. the entropy of Q relative to P . For Statement 5 observe that Lemma 3. ∞). b.2. 1. the minimizing measures are in fact minimax measures for HARA-type utility functions (cf.∞) x∈R dP   dQ  = inf E f ∗ − κ . b. ∞).4 (Distance minimization) 1. c ∈ R. the claim follows. we conclude that they lead to neutral price processes as well. Theorem 28. Lemma 3.observed that for some standard “distances”. then the neutral pricing measure minimizes −E(log dQ dP dP )) = E(log dQ )) over all equivalent martingale measures Q. By Rockafellar (1970). If u(x) = −a exp(−bx) + c for some a. c ∈ R and any x ∈ R. c = 0. ∞).o. κ∈(0. this equals − sup inf{E(f (X)) + κEQ (X) : X random variable} κ∈(0. c ∈ R and any x ∈ (−b. In view of the previous lemma. Rockafellar (1970). Note that sup{E(u(e + X − EQ (X))) : X random variable} = − inf{E(f (X)) : X random variable with EQ (X) ≤ 0}. 4.3 holds also for non-increasing u if EMM is replaced with SMM.∞)   dQ  = inf E − inf f (x) + κ x κ∈(0. If u(x) = a(x+b)p +c for some p ∈ (0.

Recall that P ? is an equivalent martingale measure if u is strictly increasing on its effective domain. .5 (Global L2 -approximation pricing) We call S0m+1 . Similarly as in the last subsection. ϕ ∈ S({0}. we have E((Rm+i − S0m+i − ψ > · ST )(y + ϕ> · ST )) = 0 for any y ∈ R. . . .2 Local utility In this subsection. Fix a utility function u such that 0 belongs to the interior of the effective domain of u. . It is well-known that the global L2 -approximation price can be obtained as expectation of the payoff under the variance-optimal signed martingale measure. it can also be interpreted as a neutral price. b. . . . . . then the global L2 - approximation prices are the initial values of the neutral price processes for terminal wealth. S m such that u0 (ϕ> 0 > t ∆St ) 6= 0 and E(u (ϕt ∆St )|Ft−1 ) 6= 0 P -almost surely for t = 1. n}. n. . there exists a strategy ψ ∈ S({0}. we consider the local utility-based version of neutral pricing. Rm ) such that     m+i m+i > 2 m+i > 2 E (R − S0 − ψ · ST ) ≤ E (R − ye − ψ · ST ) e for any ye ∈ R and any strategy ψe ∈ S({0}. c ∈ R. . cf. T (cf. Rm )-dual measure for local utility P ? neutral pricing measure for local utility. P ROOF. Rm+n )) and satisfies ϕm+1 = . Therefore. . Mathematically speaking. Schweizer (1996). . ? Since u0 (x) = −2ax − 2ab.  3. Hence. Fix i ∈ {1.e. i. . Lemma 2. Observe that S0m+i + ψ > · ST in the previous definition is the L2 -projection of Rm+i on the vector space {y + ϕ> · ST : y ∈ R. Rm ). for ({0}. . we have in particular E((Rm+i − S0m+i − ψ > · ST ) dP dP ) = 0 for the neutral pricing measure for terminal wealth (cf.14). Definition 3. This in turn implies that S0m+i = EP ? (Rm+i − ψ > · ST ) = EP ? (Rm+i ). . . the claim is projected onto the space of replicable payoffs. . ϕ = S({0}. . since neutral prices may lead to arbitrage in this case. 18 . Rm ). S m+n which is locally optimal (without constraints. . Lemma 2. The optimal initial investment y ∈ R has been suggested as a pricing rule e. .4. Rm ). S0m+n ∈ R global L2 -approximation derivative prices if. for i = 1. which in turn corresponds to the case p = 2 in Statement 5 of Lemma 3. .6 If u(x) = −a(x + b)2 + c for some a > 0. one should use this valuation rule with care.7 We call derivative price processes S m+1 . . S m+n neutral derivative price processes for local utility if there exists a strategy ϕ in the extended market S 0 . However.g. This problem has been studied extensively. = ϕm+n = 0. .strategy ψ ∈ S({0}. Rm )}. . by Schäl (1994). Lemma 3. We call the unique ({0}. . Schweizer (1999) for an overview. we assume that there exists a locally optimal strategy ϕ in the underlyings’ market S 0 . Definition 3. . . .6).

i = 1.Theorem 3. . A local L2 -approximation procedure has been suggested by Föllmer and Schweizer (1989) for contingent claim hedging (cf. Schweizer (1995a). .g. .2. The minimal martingale measure has been proposed for derivative pricing e. . . In particular. S m+n if u is strictly increasing on its effective domain. . . . T we have  2 .8 There exist unique neutral derivative price processes. They are given by Stm+i = EP ? (Rm+i |Ft ) for t = 0. . Definition 3. the subsequent definition). . Rm ) such that the following condition holds: For t = 1. . . S m+n appearing in that procedure are obtained via conditional expectation relative to the (signed) minimal martingale measure in the sense of Föllmer and Schweizer (1991). . for i = 1.  Note that P ? is an EMM for the extended market S 0 . . . . . . . S m+n local L2 -approximation price processes if. We call S m+1 . . . . This is shown in the same way as Theorem 3. .9 (Local L2 -approximation pricing) Let S m+1 . Lemma 3. the corresponding price system allows no arbitrage. . . n. S m+n be derivative price processes. . (1992). . . P ROOF. . . T . in Hofmann et al. . there exists a strategy ψ ∈ S({0}. The processes S m+1 . . n.10 shows that they can be interpreted in terms of neutral pricing for local utility.

  2 .

 E Stm+i − m+i St−1 − ψt> ∆St .

Ft−1 ≤ E St − Y − ξ ∆St .

Ft−1 m+i > .

.

Theorem 2. which proves the claim. In particular. Schweizer (1995a).15). .12). Fix i ∈ {1. ξ Ft−1 -measurable random > variables with values in R resp. . . we have E((Stm+i − St−1 m+i − ψt> ∆St )(y + ξ > ∆St )|Ft−1 ) = 0 for any such y. Rm }. Even so. . .  In general. the neutral pricing measure for local utility is the minimal martingale measure in the sense of Föllmer and Schweizer (1991). then the local L2 - approximation price processes are the neutral price processes for local utility. neutral prices for terminal wealth and for local utility do in fact coincide for logarithmic utility: 19 . for all Ft−1 -measurable. . R × Rm -valued random variables (Y. T }. we have E((Stm+i − St−1 m+i − ψt> ∆St )(1 + ∆Nt )|Ft−1 ) = 0. where N denotes the logarithm process of the neutral pricing mea- sure P ? for local utility (cf. This implies EP ? (Stm+i − St−1 m+i |Ft−1 ) = m+i m+i > m+i ? EP ? (St − St−1 − ψt ∆St |Ft−1 ) = 0. ξ. . Lemma 3. c ∈ R. ξ). neutral prices for terminal wealth and for local utility differ even if the same utility function is chosen. Hence. . Observe that St−1 + ψt> ∆St is the 2 L -projection of St m+i on the vector space {y + ξ ∆St : y. a main motivation to introduce local utility maximization was that hedging strategies and neutral pricing measures can be computed more easily (cf. n} and t ∈ {1. Indeed. b. In other words.10 If u(x) = −a(x + b)2 + c for some a > 0. m+i P ROOF. Lemma 2. Consequently S is a P -martingale.

> dP 1 > Q > Define ψ ∈ S({0}. then the neutral pricing measures for terminal wealth and for local utility coincide. b ∈ (− min(1. Moreover. c. . e. Let us now consider the more realistic situ- ation that some traders (from now on called other investors) behave differently.o. . She is interested in the distribution of future asset price changes. c ∈ R. W. This demand is reflected in the initially observed market quotations. They may e. T . we relax the market clearing condition from the previous section as follows: 20 . If you are an issuer of a con- tingent claim that is not yet traded.Lemma 3. market prices must be such that the number of derivatives in their optimal portfolio exactly offsets the demand from the other traders. From Lemma 3. . For her. c and the initial endowment e. a positive demand by the other investors should lead to market prices which are higher than the neutral value in order to prompt utility maximizers to sell contingent claims. . b. Then 1+∆Nt = (κt (b+ϕ > t ∆St )) −1 and hence ? T 1 = E(κt (b + ϕt ∆St )(1 + ∆Nt )|Ft−1 ) = κt b.l. . this measure does not depend on a.  4 Consistent derivative pricing In practise. ∞). . b. the pricing measures from the previous section can be used for this purpose as well.4 it follows that the neutral pricing measure for terminal wealth does not depend on a. . So one may doubt whether they provide a good description of future price movements.g. Hence the second statement holds as well. We make the simplifying assumption that the aggregate demand from the other investors is deterministic and constant. The situation is different for a risk man- ager who must assess the riskyness of a company’s portfolio. Intuitively. e). a = 1. How are market prices affected if the aggregate demand for derivatives by these other investors does not sum up to 0? Since the utility maximizers have to take the counterposition. . the current derivative quotations are observable in the market. Of course. especially for short time horizons. However. P ROOF.6. typically neutral derivative prices do not match observed quotations exactly even at time 0. In the derivation of neutral prices we assumed that all participants in the derivative mar- ket are identical expected utility maximizers. Suppose that ϕ ∈ S({0}.g. Rm ) is locally optimal and let P ? be the neutral pricing measure for local utility with logarithm process N . the approaches in the previous section provide some guidance as to what a reasonable price could be. Rm ) recursively by ψt := ϕt b+e+ψb ·St−1 for t = 1. Therefore dP = t=1 (1 + b ϕ ∆St )−1 . valuation rules are used for different purposes. A simple ? calculation yields that dP dP = (e + b)(b + e + ψ > · ST )−1 = (e + b)u0 (e + ψ > · ST ). In view of Lemma 2. this implies that P ? is the neutral pricing measure for terminal wealth. Moreover. It would be more satisfactory to use a valuation rule that incorporates the initially observed market quotations. let κt := E(u0 (ϕ>t ∆St )|Ft−1 ) for t = 1. Put differently.11 If u(x) = a log(x + b) + c for some a > 0. T . A solution of this kind is presented in this section. c = 0. take a derivative position for insurance purposes.

2 below. . n. . By Lemma 2. S m+n does not depend on the particular choice of consistent deriva- tive price processes S m+1 . .4 there is no such arbitrage if and only if threre exists an equivalent ({0} × Rn . . we may assume that there exists an optimal strategy ϕ for terminal wealth under the constraints ({0} × Rn . . Björk (1997)). or put differently. . . . We call the corresponding ({0} × Rn . . S m if u is strictly increasing on its effective domain. This situation occurs if the market S 0 . Moreover. m + n are given in terms of their discounted FT -measurable pay- off Rm+1 . n. we assume that derivative securities m + 1. . . For a discussion of Avellaneda et al. Derivative prices should be such that the optimal portfolio of the representative utility maximizer contains a constant number of any contingent claim. . . . Rm+n . we suppose that E(u0 (e + ϕ> · ST )|Ft ) 6= 0 P - almost surely for t = 0. . . . . . . . . suppose that their initial prices π m+1 . π m+n ∈ R are given. T . . . The Heath-Jarrow- Morton approach in interest rate theory avoids the consistency problem elegantly by treating bonds as underlyings rather than derivatives on the short rate. S m+n consistent derivative price processes if STm+i = Rm+i and S0m+i = π m+i for i = 1. As in the approach below a pricing measure is chosen from a parametric set of EMM’s in such a way that theoretical and observed initial prices match. We call adapted processes S m+1 . . . . Moreover. Therefore. Rm × {0})- dual measure P ? for terminal wealth the least favourable consistent pricing measure. . . . Such prices are called constant demand price processes in Definition 4. . . . Recall that P ? is an EMM for S 0 . . Recently.e. . . . Observe that any choice of consistent price processes leads to arbitrage if the initial prices are unreasonably chosen. S m+n in the first place. i. Avellaneda (1998) cf. the derivatives have to be traded only at times 0 and T in order to obtain a riskless gain. . . the end of this section. As before. . . By Lemma 2. S m+n . . . But we can hope for unique constant demand price processes that match initially observed market quotations. . . these assumptions follow from the absence of arbitrage for decent utility functions. . 21 . . S m+n allows ({0} × Rn . The general setting is as in the previous section. Of course. The issue of consistent derivative pricing is barely touched in the literature.9. Consistent signed martingale measures (CSMM) are defined accordingly. . Maybe closest in spirit is the concept of inverting the yield curve in interest rate theory (cf. Rm × {0})-arbitrage. Rm × {0}) without fixing S m+1 . a consistent equivalent martingale measure in the sense of the following Definition 4. Fix an initial endowment e ∈ R and a utility function u such that e belongs to the interior of the effective domain of u. (1997). we cannot hope any more for unique derivative prices in this more general setting. Note that the terminal wealth of strategies ϕ ∈ S({0} × Rn . Rm × {0}) in the ex- tended market S 0 . Rm × {0})-seperating measure. In Kallsen (2001) a local utility-based variant of consistent pricing is discussed.1 We call an EMM P ? consistent equivalent martingale measure (CEMM) if EP ? (Rm+i ) = π m+i for i = 1. Kallsen (1998a) and Goll and Rüschendorf (2000) addressed this issue.

3 There exist unique constant demand derivative price processes. n. . .3: Lemma 4. (1997) and Avellaneda (1998) suggest to calibrate a market model to initially observed derivative quotations π m+1 .2 if the neutral pricing measure is replaced with the least favourable consistent pricing measure. Distance minimizing CEMM’s are considered in Goll and Rüschendorf (2000). In view of the previous lemma this seems to be closely related to constant demand derivative pricing. Theorem 4.4 (Least favourable market completion) If u is strictly increasing on its effec- tive domain.e. their minimization extends over a larger class of probability measures Q that reproduce the observed initial prices. However. P ROOF. . . . then the least favourable consistent pricing measure P ? minimizes sup{E(u(e + X − EQ (X))) : X FT -measurable random variable} over all consistent equivalent martingale measures Q. T . . .4 also has a counterpart for consistent pricing. 22 . . either the equivalence to P (cf. Avellaneda et al. . i = 1. This is shown similarly as Theorem 3. the resulting price system is typically not arbitrage-free. . ϕm+n = am+n for some constants am+1 .  The name least favourable consistent pricing measure is motivated by the following analogue of Lemma 3. CSMM). . . They are given by Stm+i = EP ? (Rm+i |Ft ) for t = 0. . . .  The following result shows that Lemma 3. . . Rm+n )) and satisfies ϕm+1 = am+1 . It is shown exactly in the same way. for ({0}.2 We call consistent price processes S m+1 . . . (1997)) or the martingale property of S (cf. Avellaneda (1998)) is dropped. .4 still holds if neutral pricing measure is replaced with least favourable consistent pricing measure and EMM (resp. am+n ∈ R. . i. . S m+n which is optimal for terminal wealth (without constraints. . P ROOF.5 (Distance minimization) Lemma 3. .Definition 4. This allows for easier numerical computations but applied to our setting. . In these papers. Lemma 4. . SMM) with CEMM (resp. .3. instead of focusing on equivalent martingale measures. S m+n constant demand deriva- tive price processes if there exists a strategy ϕ in the extended market S 0 . Avellaneda et al. . This is shown in the same way as Lemma 3. π m+n by minimizing the entropy or pseudo entropy of the pricing measure relative to P .

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