Prices of Risk

Affiliation(s)

Quantitative Analytics, Global Markets, ANZ Bank, Singapore City, Singapore.

ABSTRACT

We review the nature of some well-known phenomena such as volatility smiles, convexity
adjustments and parallel derivative markets. We propose that the market is incomplete and
postulate the existence of intrinsic risks in every contingent claim as a basis for understanding
these phenomena. In a continuous time framework, we bring together the notion of intrinsic
risk and the theory of change of measures to derive a probability measure, namely risksubjective measure, for evaluating contingent claims. This paper is a modest attempt to prove
that measure of intrinsic risk is a crucial ingredient for explaining these phenomena, and in
consequence proposes a new approach to pricing and hedging financial derivatives. By
adapting theoretical knowledge to practical applications, we show that our approach is
consistent and robust, compared with the standard risk-neutral approach.
KEYWORDS

Implied Volatility, Convexity Adjustment, Primary and Parallel Markets, Incomplete Markets,
Intrinsic Risk, Risk-Neutral Measure, Risk-Subjective Measure, Fair Valuation, DeltaHedging
Cite this paper

Le, T. (2014) Intrinsic Prices of Risk. Journal of Mathematical Finance, 4, 318-327. doi:
10.4236/jmf.2014.45029.
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