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 âunderlyingâ 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.â 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: âAn exact formula for an asset price, based on observable variables only, is a rare finding in a general equilibrium model . . .â. 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
The Journal of Finance – Wiley
Published: Mar 1, 1979
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