Esscher transforms and consumption-based models

Alex Badescu, Robert J. Elliott, Tak Kuen Siu*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

12 Citations (Scopus)

Abstract

The Esscher transform is an important tool in actuarial science. Since the pioneering work of Gerber and Shiu (1994), the use of the Esscher transform for option valuation has also been investigated extensively. However, the relationships between the asset pricing model based on the Esscher transform and some fundamental equilibrium-based asset pricing models, such as consumption-based models, have so far not been well-explored. In this paper, we attempt to bridge the gap between consumption-based models and asset pricing models based on Esscher-type transformations in a discrete-time setting. Based on certain assumptions for the distributions of asset returns, changes in aggregate consumptions and returns on the market portfolio, we construct pricing measures that are consistent with those arising from Esscher-type transformations. Explicit relationships between the market price of risk, and the risk preference parameters are derived for some particular cases.

Original languageEnglish
Pages (from-to)337-347
Number of pages11
JournalInsurance: Mathematics and Economics
Volume45
Issue number3
DOIs
Publication statusPublished - Dec 2009

Keywords

  • Consumption-based model
  • Esscher transform
  • Esscher-Girsanov transform
  • Euler equation
  • Exponential affine form
  • Radon-Nikodym derivative
  • Stochastic discount factor
  • Utility function

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