Walter Schachermayer

The Limitations of No-Arbitrage Arguments for Real Options.

F. Hubalek, W. Schachermayer
International Journal of Theoretical and Applied Finance, Vol. 4 (2001), No. 2, pp. 361-373. 

Abstract:

We consider an option c which is contingent on an underlying S~ that is not a traded asset. This situation typically arises in the context of real options. We investigate the situation when there is a 'surrogate' traded asset S whose price process is highly correlated with that of S~. An illustration would be the cases where S and S~ model two different brands of crude oil. The main result of the paper shows that in this case one cannot draw any non­trivial conclusions on the price of the option by only using no arbitrage arguments.

In a second step we try to isolate hedging strategies on the traded asset S which minimize the variance of the hedging error. We show in particular, that the naive strategy of simply replacing S~ by S fails to be optimal and we are able to quantify how far it is from being optimal.

Preprints:

Publications marked with have appeared in refereed journals.

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