Benchmark-Neutral Pricing

TL;DR

This paper proposes a benchmark-neutral pricing method for long-term claims using the growth optimal portfolio as a numeraire, resulting in minimal prices that improve over traditional risk-neutral approaches.

Contribution

It introduces a new benchmark-neutral pricing measure that often yields lower, more accurate prices for long-term contracts compared to risk-neutral pricing.

Findings

Benchmark-neutral prices are often lower than risk-neutral prices.

The method accurately prices long-term zero-coupon bonds.

The pricing measure is an equivalent probability measure in realistic models.

Abstract

The paper introduces benchmark-neutral pricing and hedging for long-term contingent claims. It employs the growth optimal portfolio of the stocks as numeraire and the new benchmark-neutral pricing measure for pricing. For a realistic parsimonious model, this pricing measure turns out to be an equivalent probability measure, which is not the case for the risk-neutral pricing measure. Many risk-neutral prices of long-term contracts are more expensive than necessary. Benchmark-neutral pricing identifies the minimal possible prices of contingent claims, which is illustrated with remarkable accuracy for a long-term zero-coupon bond.