Utility indifference valuation for non-smooth payoffs with an application to power derivatives

DOI10.1007/S00245-015-9306-4zbMATH Open1342.60102arXiv1307.4591OpenAlexW1749637740MaRDI QIDQ282083FDOQ282083

Authors: Giuseppe Benedetti, Luciano Campi 

Publication date: 12 May 2016

Published in: Applied Mathematics and Optimization (Search for Journal in Brave)

Abstract: We consider the problem of exponential utility indifference valuation under the simplified framework where traded and nontraded assets are uncorrelated but where the claim to be priced possibly depends on both. Traded asset prices follow a multivariate Black and Scholes model, while nontraded asset prices evolve as generalized Ornstein-Uhlenbeck processes. We provide a BSDE characterization of the utility indifference price (UIP) for a large class of non-smooth, possibly unbounded, payoffs depending simultaneously on both classes of assets. Focusing then on European claims and using the Gaussian structure of the model allows us to employ some BSDE techniques (in particular, a Malliavin-type representation theorem due to Ma (2002)) to prove the regularity of Z and to characterize the UIP for possibly discontinuous European payoffs as a viscosity solution of a suitable PDE with continuous space derivatives. The optimal hedging strategy is also identified essentially as the delta hedging strategy corresponding to the UIP. Since there are no closed-form formulas in general, we also obtain asymptotic expansions for prices and hedging strategies when the risk aversion parameter is small. Finally, our results are applied to pricing and hedging power derivatives in various structural models for energy markets.

Full work available at URL: https://arxiv.org/abs/1307.4591

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zbMATH Keywords

backward stochastic differential equationsviscosity solutionselectricity marketsoptimal investmentutility indifference pricing

Mathematics Subject Classification ID

Stochastic calculus of variations and the Malliavin calculus (60H07) Stochastic ordinary differential equations (aspects of stochastic analysis) (60H10) Viscosity solutions to Hamilton-Jacobi equations in optimal control and differential games (49L25) Applications of stochastic analysis (to PDEs, etc.) (60H30) Financial applications of other theories (91G80) Duality theory (optimization) (49N15)

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Cited In (13)

• Any-utility neutral and indifference pricing and hedging
• Indifference pricing of insurance-linked securities in a multi-period model
• Indifference pricing and hedging in a multiple-priors model with trading constraints
• Utility indifference pricing and hedging for structured contracts in energy markets
• On the parabolic equation for portfolio problems
• Indifference pricing of a power utility function under a discrete-time model
• Valuation of power plants by utility indifference and numerical computation
• Pseudo linear pricing rule for utility indifference valuation
• Indifference pricing for CRRA utilities
• Pricing and hedging of derivatives based on nontradable underlyings
• Asymptotic power utility-based pricing and hedging
• Utility–indifference hedging and valuation via reaction–diffusion systems
• Exponential utility indifference valuation in two Brownian settings with stochastic correlation

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