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Conic asset pricing and the costs of price fluctuations

  • Dilip B. Madan
  • Wim Schoutens
Research Article

Abstract

Prudent upper and lower valuations from the literature on arbitrage free two price economies provide risk characteristics driving required returns. The risk characteristics assess the risk of price fluctuations. The difference between the upper and lower prudent valuations can be viewed as a capital charge. In addition the lower valuation assesses the down side tail risk. The required risk characteristics may be estimated on a daily basis from past data and we elaborate on how to perform such upper and lower valuations using distorted expectations. Details are provided for calculations using just the raw data, or by first fitting a probability distribution, or in terms of estimated arrival rates for jumps. The valuations are obtained with a dynamic calibration of a parametric distortion on the S&P 500 index options market. Results for required returns based on capital charges and down side risk compensation show an improvement when risk is represented by the arrival rates of jump sizes. For risk assessments based on arrival rates, capital charges constitute between 67 and 85% of the required return. The rest being a charge for downside risk exposures. After the introduction of risk characteristics into required returns there is little scope for covariation measures like asset betas. Different proposed constructions for required returns deliver differences in the value of an invested dollar and associated differences in asset rankings across time.

Keywords

Probability distortion Measure distortion Self decomposable law Variance gamma model 

JEL Classification

G10 G12 G13 

Notes

Compliance with ethical standards

Conflict of interest

Both the authors declare that there is no conflict of interest.

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Copyright information

© Springer-Verlag GmbH Germany, part of Springer Nature 2018

Authors and Affiliations

  1. 1.Robert H. Smith School of BusinessUniversity of MarylandCollege ParkUSA
  2. 2.K. U. LeuvenLeuvenBelgium

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