A note on utility based pricing and asymptotic risk diversification

Bruno Bouchard (1, 2) , Romuald Elie (1, 2) , Ludovic Moreau (1)

1 CEREMADE - CEntre de REcherches en MAthématiques de la DEcision
2 CREST - Centre de Recherche en Économie et Statistique

In principle, liabilities combining both insurancial risks (e.g. mortality/longevity, crop yield,...) and pure financial risks cannot be priced neither by applying the usual actuar- ial principles of diversification, nor by arbitrage-free replication arguments. Still, it has been often proposed in the literature to combine these two approaches by suggesting to hedge a pure financial payoff computed by taking the mean under the historical/objective probability measure on the part of the risk that can be diversified. Not surprisingly, simple examples show that this approach is typically inconsistent for risk adverse agents. We show that it can nevertheless be recovered asymptotically when the number of sold claims goes to infinity and the absolute risk aversion of the agent goes to zero simultaneously. This follows from a general convergence result on utility indifference prices which is valid for both complete and incomplete financial markets. In particular, if the underlying financial market is complete, the limit price corresponds to the hedging cost of the mean payoff. If the financial market is incomplete but the agent behaves asymptotically as an exponential utility maximizer with vanishing risk aversion, we show that the utility indifference price converges to the expectation of the discounted payoff under the minimal entropy martingale measure.

Mots clés: Utility indifference pricing; diversification; risk aversion; entropy

Domaines: Probabilités [math.PR]

Bruno Bouchard, Romuald Elie, Ludovic Moreau. A note on utility based pricing and asymptotic risk diversification. Mathematics and Financial Economics, 2011, 6 (1), pp.59-74. ⟨hal-00617124⟩