A valuation algorithm for indifference prices in incomplete markets (Q1776009)

The aim of the paper is to build a probabilistic algorithm for indifference prices and to offer new insights for the utility based valuation methodology. The indifference price is specified through two stochastic optimization problems of expected utility for the plain investor and for the writer, or the buyer, of the claim. This work contributes in further exploring the indifference pricing mechanism through a representation of prices as iterative output of a probabilistic valuation scheme. The scheme is essentially nonlinear and, at each time, has the ability to identify, isolate and price the unhedgeable risks. This is executed via a sequential pricing procedure that combines actuarial and arbitrage type arguments. Despite the underlined highly nonlinear nature of the utility based valuation, the algorithm yields prices that preserve the time consistency (semigroup) property, a rather indispensable ingredient of any viable pricing theory. The entire analysis is based on the assumption of exponential preferences.