Beyond Arbitrage: "Good-Deal" Asset Price Bounds in Incomplete Markets
John H. Cochrane, Jesus Saa-Requejo
NBER Working Paper No. 5489
It is often useful to price assets and other random payoffs by reference to other observed prices rather than construct full-fledged economic asset pricing models. This approach breaks down if one cannot find a perfect replicating portfolio. We impose weak economic restrictions to derive usefully tight bounds on asset prices in this situation. The bounds basically rule out high Sharpe ratios - `good deals' - as well as arbitrage opportunities. We present the method of calculation, we extend it to a multiperiod context by finding a recursive solution, and we apply it to option pricing examples including the Black-Scholes setup with infrequent trading, and a model with stochastic stock volatility and a varying riskfree rate.
Published: Journal of Political Economy (February 2000 Revision of W5489, March 1996)