An example of indifference prices under exponential preferences

Abstract.

The aim herein is to analyze utility-based prices and hedging strategies. The analysis is based on an explicitly solved example of a European claim written on a nontraded asset, in a model where risk preferences are exponential, and the traded and nontraded asset are diffusion processes with, respectively, lognormal and arbitrary dynamics. Our results show that a nonlinear pricing rule emerges with certainty equivalent characteristics, yielding the price as a nonlinear expectation of the derivative’s payoff under the appropriate pricing measure. The latter is a martingale measure that minimizes its relative to the historical measure entropy.