Pricing under the Benchmark Approach

Abstract

The paper summarizes key results of the benchmark approach with a focus on the concept of benchmark-neutral pricing. It applies these results to the pricing of an extreme-maturity European put option on a well-diversified stock index. The growth optimal portfolio of the stocks is approximated by a well-diversified stock portfolio and modeled by a drifted time-transformed squared Bessel process of dimension four. It is shown that the benchmark-neutral price of a European put option is theoretically the minimal possible price and the respective risk-neutral put price turns out to be significantly more expensive.