|
Abstract
|
|---|
What is the fair price of an option, in a market where the volatility is stochastic? We answer this question by introducing the "relative indifference price". This is the price at which a trader is indifferent to trade in an additional option, given that he is currently holding and dynamically hedging a portfolio of options. We find that the appropriate volatility risk premium depends on the trader's risk aversion and his portfolio position before selling or buying the additional option. This approach provides a tool for traders to (i) integrate option pricing with risk management and (ii) quote competitive prices that depend on their aggregate risk exposure. |
|
|