Utility Indifference Pricing: A Time Consistent Approach

TL;DR

This paper develops a time consistent utility indifference pricing method for a multi-period stochastic market with regime switching, involving incomplete markets and regime-dependent risk preferences, using equilibrium strategies and numerical analysis.

Contribution

It introduces a novel approach to utility indifference pricing in regime-switching models with time inconsistency, employing subgame perfect equilibrium strategies.

Findings

Prices vary with model parameters in numerical experiments.

Regime switching impacts optimal strategies and pricing.

Method handles incomplete markets with non-tradable assets.

Abstract

This paper considers the optimal portfolio selection problem in a dynamic multi-period stochastic framework with regime switching. The risk preferences are of exponential (CARA) type with an absolute coefficient of risk aversion which changes with the regime. The market model is incomplete and there are two risky assets: one tradable and one non-tradable. In this context, the optimal investment strategies are time inconsistent. Consequently, the subgame perfect equilibrium strategies are considered. The utility indifference prices of a contingent claim written on the risky assets are computed via an indifference valuation algorithm. By running numerical experiments, we examine how these prices vary in response to changes in model parameters.