An Alternative Valuation Model for Contingent Claims

THE CHARLES A. DICE CENTER FOR RESEARCH IN FINANCIAL ECONOMICS

36 Pages Posted: 29 Feb 1996

See all articles by Zhiwu Chen

Zhiwu Chen

University of Hong Kong, Faculty of Business Economics (HKU Business School); Asia Global Institute, University of Hong Kong

Gurdip Bakshi

Fox School of Business; Temple University - Fox School of Business and Management

Date Written: September 1995

Abstract

The fundamental valuation equation of Cox, Ingersoll and Ross was expressed in terms of the indirect utility of wealth function. As closed-form solution for the indirect utility is generally unobtainable when investment opportunities are stochastic, existing contingent claims models involving general stochastic processes were almost all derived under the restrictive log utility assumption. An alternative valuation equation is proposed here that depends only on the direct utility function. This alternative valuation approach is applied to derive closed-form solutions for bonds, bond options, individual stocks, and stock options under both power utility and exponential utility functions. Allowable processes for aggregate output, firms' dividends, and state variables are quite general and empirically plausible. The resulting interest rate and stock price dynamics have many empirically plausible properties. Our bond and stock option pricing models with stochastic volatility and stochastic interest rates have most existing models nested. The stock option pricing model is also shown to have the ability to reconcile certain puzzling empirical regularities such as the volatility smile.

JEL Classification: G13

Suggested Citation

Chen, Zhiwu and Bakshi, Gurdip S. and Bakshi, Gurdip S., An Alternative Valuation Model for Contingent Claims (September 1995). THE CHARLES A. DICE CENTER FOR RESEARCH IN FINANCIAL ECONOMICS, Available at SSRN: https://ssrn.com/abstract=40861 or http://dx.doi.org/10.2139/ssrn.40861

Zhiwu Chen

University of Hong Kong, Faculty of Business Economics (HKU Business School) ( email )

Pokfulam Road
Hong Kong
Hong Kong

Asia Global Institute, University of Hong Kong ( email )

Room 328-348, Main Building
The University of Hong Kong
Pokfulam
Hong Kong

Gurdip S. Bakshi (Contact Author)

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

Temple University - Fox School of Business and Management ( email )

Philadelphia, PA 19122
United States

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

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