We develop a model for indifference pricing in derivatives markets where price quotes have bid-ask spreads and finite quantities. The model quantifies the dependence of the prices and hedging portfolios on an investors beliefs, risk preferences and financial position as well as on the price quotes. Computational techniques of convex optimization allow for fast computation of the hedging portfolios and prices as well as sensitivities with respect to various model parameters. We illustrate the techniques by pricing and hedging of exotic derivatives on S&P index using call and put options, forward contracts and cash as the hedging instruments. The optimized static hedges provide good approximations of the options payouts and the spreads between indifference selling and buying prices are quite narrow as compared with the spread between super- and subhedging prices.

This is joint work with John Armstrong and Udomsak Rakwongwan, from King's College London.

Bio:

Teemu Pennanen is the Professor of Financial Mathematics, probability and statistics at King's College London. Before joining KCL, professor Pennanen worked as Managing Director at QSA Quantitative Solvency Analysts Ltd, with a joint appointment as Professor of Mathematics at the University of Jyvaskyla. His research interests include convex optimization, probability and statistics and their applications to financial economics and risk management. Pennanen has authored over 50 journal publications and he has been a consultant to a number of financial institutions including Bank of Finland, The State Pension Fund and Ministry of Social Affairs and Health.