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Esscher transforms and consumption-based models
Authors:Alex Badescu  Tak Kuen Siu
Institution:a Department of Mathematics and Statistics, University of Calgary, Calgary, Alberta, Canada
b Haskayne School of Business, University of Calgary, Calgary, Alberta, Canada
c Department of Mathematical Sciences, University of Adelaide, Adelaide, Australia
d Department of Actuarial Studies and Center of Financial Risk, Faculty of Business and Economics, Macquarie University, Sydney, Australia
Abstract:The Esscher transform is an important tool in actuarial science. Since the pioneering work of Gerber and Shiu (1994), the use of the Esscher transform for option valuation has also been investigated extensively. However, the relationships between the asset pricing model based on the Esscher transform and some fundamental equilibrium-based asset pricing models, such as consumption-based models, have so far not been well-explored. In this paper, we attempt to bridge the gap between consumption-based models and asset pricing models based on Esscher-type transformations in a discrete-time setting. Based on certain assumptions for the distributions of asset returns, changes in aggregate consumptions and returns on the market portfolio, we construct pricing measures that are consistent with those arising from Esscher-type transformations. Explicit relationships between the market price of risk, and the risk preference parameters are derived for some particular cases.
Keywords:Esscher transform  Esscher-Girsanov transform  Consumption-based model  Stochastic discount factor  Exponential affine form  Euler equation  Radon-Nikodym derivative  Utility function
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