Stochastic relaxational dynamics applied to finance: towards non-equilibrium option pricing theory

TL;DR

This paper introduces a novel non-equilibrium option pricing model using stochastic relaxational dynamics and path integrals, accounting for virtual arbitrage returns and intermediate deviations from equilibrium, leading to more accurate pricing and hedging insights.

Contribution

It extends existing models by incorporating relaxational dynamics with stochastic noise into option pricing, providing exact formulas and a new perspective on hedging in incomplete markets.

Findings

Derived exact pricing formulas for European options under virtual arbitrage influences.

Identified an additional positive risk premium over Black-Scholes due to intermediate deviations.

Showed the hedging strategy is not self-financing in practice but is when averaged over the derivative's lifetime.

Abstract

Non-equilibrium phenomena occur not only in physical world, but also in finance. In this work, stochastic relaxational dynamics (together with path integrals) is applied to option pricing theory. A recently proposed model (by Ilinski et al.) considers fluctuations around this equilibrium state by introducing a relaxational dynamics with random noise for intermediate deviations called ``virtual'' arbitrage returns. In this work, the model is incorporated within a martingale pricing method for derivatives on securities (e.g. stocks) in incomplete markets using a mapping to option pricing theory with stochastic interest rates. Using a famous result by Merton and with some help from the path integral method, exact pricing formulas for European call and put options under the influence of virtual arbitrage returns (or intermediate deviations from economic equilibrium) are derived where only the final integration over initial arbitrage returns needs to be performed numerically. This result is complemented by a discussion of the hedging strategy associated to a derivative, which replicates the final payoff but turns out to be not self-financing in the real world, but self-financing {\it when summed over the derivative's remaining life time}. Numerical examples are given which underline the fact that an additional positive risk premium (with respect to the Black-Scholes values) is found reflecting extra hedging costs due to intermediate deviations from economic equilibrium.