The Pricing of Contingent Claims in Discrete Time Models

The Pricing of Contingent Claims in Discrete Time Models The Pricing of Contingent Claims in Discrete Time Models M.J. BRENNAN* THEESSENTIAL FEATURE OF modern option pricing theory is the derivation of risk neutral valuation relationships (RNVRs) for contingent claims. A contingent claim is an asset whose payoff depends upon the value of another “underlying” asset, the value of which is exogenously determined: a valuation relationship is a formula relating the value of the contingent claim, or its derivatives, to the value of the underlying asset and other exogenous parameters.’ If the valuation relationship is risk-neutral, it is compatible with the assumption of risk neutral investor preferences, under which all securities have the same expected rate of return. A risk neutral valuation relationship depends only upon potentially observable parameters and it is extremely significant that such a relationship can be derived from only weak assumptions about investor preferences, for, as Merton [lo] has observed: “An exact formula for an asset price, based on observable variables only, is a rare finding in a general equilibrium model . . .”. RNVRs have been derived from two quite different general classes of model: the first class places no restrictions on investor preferences beyond the assumption of non-satiety, but assumes that asset http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Finance Wiley

The Pricing of Contingent Claims in Discrete Time Models

The Journal of Finance, Volume 34 (1) – Mar 1, 1979

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Publisher
Wiley
Copyright
1979 The American Finance Association
ISSN
0022-1082
eISSN
1540-6261
D.O.I.
10.1111/j.1540-6261.1979.tb02070.x
Publisher site
See Article on Publisher Site

Abstract

The Pricing of Contingent Claims in Discrete Time Models M.J. BRENNAN* THEESSENTIAL FEATURE OF modern option pricing theory is the derivation of risk neutral valuation relationships (RNVRs) for contingent claims. A contingent claim is an asset whose payoff depends upon the value of another “underlying” asset, the value of which is exogenously determined: a valuation relationship is a formula relating the value of the contingent claim, or its derivatives, to the value of the underlying asset and other exogenous parameters.’ If the valuation relationship is risk-neutral, it is compatible with the assumption of risk neutral investor preferences, under which all securities have the same expected rate of return. A risk neutral valuation relationship depends only upon potentially observable parameters and it is extremely significant that such a relationship can be derived from only weak assumptions about investor preferences, for, as Merton [lo] has observed: “An exact formula for an asset price, based on observable variables only, is a rare finding in a general equilibrium model . . .”. RNVRs have been derived from two quite different general classes of model: the first class places no restrictions on investor preferences beyond the assumption of non-satiety, but assumes that asset

Journal

The Journal of FinanceWiley

Published: Mar 1, 1979

References

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