The Pricing Mechanism of Contingent Claims and its Generating Function

TL;DR

This paper investigates the dynamic pricing of contingent claims using g-expectations defined by backward stochastic differential equations, providing a test-based characterization of the generating function g and validating it with CME data.

Contribution

It establishes a criterion for identifying g-pricing mechanisms through domination conditions and demonstrates this with empirical testing on market data.

Findings

The domination condition characterizes g-pricing mechanisms.

Empirical tests on CME data support the theoretical criterion.

The generating function g can be determined through testing methods.

Abstract

In this paper we study dynamic pricing mechanism of contingent claims. A typical model of such pricing mechanism is the so-called g-expectation $E^g_{s,t}[X]$ defined by the solution of the backward stochastic differential equation with generator g and with the contingent claim X as terminal condition. The generating function g this BSDE. We also provide examples of determining the price generating function $g=g(y,z)$ by testing. The main result of this paper is as follows: if a given dynamic pricing mechanism is $E^{g_\mu}$-dominated, i.e., the criteria (A5) $E_{s,t}[X]-E_{s,t}[X']\leq E^{g_\mu}_{s,t}[X-X']$ is satisfied for a large enough $\mu> 0$, where $g_\mu=g_{\mu}(|y|+|z|)$, then $E_{s,t}$ is a g-pricing mechanism. This domination condition was statistically tested using CME data documents. The result of test is significantly positive.