Commenced in January 2007
Frequency: Monthly
Edition: International
Paper Count: 877

Search results for: option pricing

877 Derivation of Fractional Black-Scholes Equations Driven by Fractional G-Brownian Motion and Their Application in European Option Pricing

Authors: Changhong Guo, Shaomei Fang, Yong He

Abstract:

In this paper, fractional Black-Scholes models for the European option pricing were established based on the fractional G-Brownian motion (fGBm), which generalizes the concepts of the classical Brownian motion, fractional Brownian motion and the G-Brownian motion, and that can be used to be a tool for considering the long range dependence and uncertain volatility for the financial markets simultaneously. A generalized fractional Black-Scholes equation (FBSE) was derived by using the Taylor’s series of fractional order and the theory of absence of arbitrage. Finally, some explicit option pricing formulas for the European call option and put option under the FBSE were also solved, which extended the classical option pricing formulas given by F. Black and M. Scholes.

Keywords: European option pricing, fractional Black-Scholes equations, fractional g-Brownian motion, Taylor's series of fractional order, uncertain volatility

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876 Implied Adjusted Volatility by Leland Option Pricing Models: Evidence from Australian Index Options

Authors: Mimi Hafizah Abdullah, Hanani Farhah Harun, Nik Ruzni Nik Idris

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With the implied volatility as an important factor in financial decision-making, in particular in option pricing valuation, and also the given fact that the pricing biases of Leland option pricing models and the implied volatility structure for the options are related, this study considers examining the implied adjusted volatility smile patterns and term structures in the S&P/ASX 200 index options using the different Leland option pricing models. The examination of the implied adjusted volatility smiles and term structures in the Australian index options market covers the global financial crisis in the mid-2007. The implied adjusted volatility was found to escalate approximately triple the rate prior the crisis.

Keywords: implied adjusted volatility, financial crisis, Leland option pricing models, Australian index options

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875 Econophysics: The Use of Entropy Measures in Finance

Authors: Muhammad Sheraz, Vasile Preda, Silvia Dedu

Abstract:

Concepts of econophysics are usually used to solve problems related to uncertainty and nonlinear dynamics. In the theory of option pricing the risk neutral probabilities play very important role. The application of entropy in finance can be regarded as the extension of both information entropy and the probability entropy. It can be an important tool in various financial methods such as measure of risk, portfolio selection, option pricing and asset pricing. Gulko applied Entropy Pricing Theory (EPT) for pricing stock options and introduced an alternative framework of Black-Scholes model for pricing European stock option. In this article, we present solutions to maximum entropy problems based on Tsallis, Weighted-Tsallis, Kaniadakis, Weighted-Kaniadakies entropies, to obtain risk-neutral densities. We have also obtained the value of European call and put in this framework.

Keywords: option pricing, Black-Scholes model, Tsallis entropy, Kaniadakis entropy, weighted entropy, risk-neutral density

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874 Basket Option Pricing under Jump Diffusion Models

Authors: Ali Safdari-Vaighani

Abstract:

Pricing financial contracts on several underlying assets received more and more interest as a demand for complex derivatives. The option pricing under asset price involving jump diffusion processes leads to the partial integral differential equation (PIDEs), which is an extension of the Black-Scholes PDE with a new integral term. The aim of this paper is to show how basket option prices in the jump diffusion models, mainly on the Merton model, can be computed using RBF based approximation methods. For a test problem, the RBF-PU method is applied for numerical solution of partial integral differential equation arising from the two-asset European vanilla put options. The numerical result shows the accuracy and efficiency of the presented method.

Keywords: basket option, jump diffusion, ‎radial basis function, RBF-PUM

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873 Random Walks and Option Pricing for European and American Options

Authors: Guillaume Leduc

Abstract:

In this paper, we describe a broad setting under which the error of the approximation can be quantified, controlled, and for which convergence occurs at a speed of n⁻¹ for European and American options. We describe how knowledge of the error allows for arbitrarily fast acceleration of the convergence.

Keywords: random walk approximation, European and American options, rate of convergence, option pricing

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872 Cuckoo Search Optimization for Black Scholes Option Pricing

Authors: Manas Shah

Abstract:

Black Scholes option pricing model is one of the most important concepts in modern world of computational finance. However, its practical use can be challenging as one of the input parameters must be estimated; implied volatility of the underlying security. The more precisely these values are estimated, the more accurate their corresponding estimates of theoretical option prices would be. Here, we present a novel model based on Cuckoo Search Optimization (CS) which finds more precise estimates of implied volatility than Particle Swarm Optimization (PSO) and Genetic Algorithm (GA).

Keywords: black scholes model, cuckoo search optimization, particle swarm optimization, genetic algorithm

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871 Option Pricing Theory Applied to the Service Sector

Authors: Luke Miller

Abstract:

This paper develops an options pricing methodology to value strategic pricing strategies in the services sector. More specifically, this study provides a unifying taxonomy of current service sector pricing practices, frames these pricing decisions as strategic real options, demonstrates accepted option valuation techniques to assess service sector pricing decisions, and suggests future research areas where pricing decisions and real options overlap. Enhancing revenue in the service sector requires proactive decision making in a world of uncertainty. In an effort to strategically price service products, revenue enhancement necessitates a careful study of the service costs, customer base, competition, legalities, and shared economies with the market. Pricing decisions involve the quality of inputs, manpower, and best practices to maintain superior service. These decisions further hinge on identifying relevant pricing strategies and understanding how these strategies impact a firm’s value. A relatively new area of research applies option pricing theory to investments in real assets and is commonly known as real options. The real options approach is based on the premise that many corporate decisions to invest or divest in assets are simply an option wherein the firm has the right to make an investment without any obligation to act. The decision maker, therefore, has more flexibility and the value of this operating flexibility should be taken into consideration. The real options framework has already been applied to numerous areas including manufacturing, inventory, natural resources, research and development, strategic decisions, technology, and stock valuation. Additionally, numerous surveys have identified a growing need for the real options decision framework within all areas of corporate decision-making. Despite the wide applicability of real options, no study has been carried out linking service sector pricing decisions and real options. This is surprising given the service sector comprises 80% of the US employment and Gross Domestic Product (GDP). Identifying real options as a practical tool to value different service sector pricing strategies is believed to have a significant impact on firm decisions. This paper identifies and discusses four distinct pricing strategies available to the service sector from an options’ perspective: (1) Cost-based profit margin, (2) Increased customer base, (3) Platform pricing, and (4) Buffet pricing. Within each strategy lie several pricing tactics available to the service firm. These tactics can be viewed as options the decision maker has to best manage a strategic position in the market. To demonstrate the effectiveness of including flexibility in the pricing decision, a series of pricing strategies were developed and valued using a real options binomial lattice structure. The options pricing approach discussed in this study allows service firms to directly incorporate market-driven perspectives into the decision process and thus synchronizing service operations with organizational economic goals.

Keywords: option pricing theory, real options, service sector, valuation

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870 Nonparametric Estimation of Risk-Neutral Densities via Empirical Esscher Transform

Authors: Manoel Pereira, Alvaro Veiga, Camila Epprecht, Renato Costa

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This paper introduces an empirical version of the Esscher transform for risk-neutral option pricing. Traditional parametric methods require the formulation of an explicit risk-neutral model and are operational only for a few probability distributions for the returns of the underlying. In our proposal, we make only mild assumptions on the pricing kernel and there is no need for the formulation of the risk-neutral model for the returns. First, we simulate sample paths for the returns under the physical distribution. Then, based on the empirical Esscher transform, the sample is reweighted, giving rise to a risk-neutralized sample from which derivative prices can be obtained by a weighted sum of the options pay-offs in each path. We compare our proposal with some traditional parametric pricing methods in four experiments with artificial and real data.

Keywords: esscher transform, generalized autoregressive Conditional Heteroscedastic (GARCH), nonparametric option pricing

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869 Robust Numerical Scheme for Pricing American Options under Jump Diffusion Models

Authors: Salah Alrabeei, Mohammad Yousuf

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The goal of option pricing theory is to help the investors to manage their money, enhance returns and control their financial future by theoretically valuing their options. However, most of the option pricing models have no analytical solution. Furthermore, not all the numerical methods are efficient to solve these models because they have nonsmoothing payoffs or discontinuous derivatives at the exercise price. In this paper, we solve the American option under jump diffusion models by using efficient time-dependent numerical methods. several techniques are integrated to reduced the overcome the computational complexity. Fast Fourier Transform (FFT) algorithm is used as a matrix-vector multiplication solver, which reduces the complexity from O(M2) into O(M logM). Partial fraction decomposition technique is applied to rational approximation schemes to overcome the complexity of inverting polynomial of matrices. The proposed method is easy to implement on serial or parallel versions. Numerical results are presented to prove the accuracy and efficiency of the proposed method.

Keywords: integral differential equations, jump–diffusion model, American options, rational approximation

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868 Application of the Concept of Comonotonicity in Option Pricing

Authors: A. Chateauneuf, M. Mostoufi, D. Vyncke

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Monte Carlo (MC) simulation is a technique that provides approximate solutions to a broad range of mathematical problems. A drawback of the method is its high computational cost, especially in a high-dimensional setting, such as estimating the Tail Value-at-Risk for large portfolios or pricing basket options and Asian options. For these types of problems, one can construct an upper bound in the convex order by replacing the copula by the comonotonic copula. This comonotonic upper bound can be computed very quickly, but it gives only a rough approximation. In this paper we introduce the Comonotonic Monte Carlo (CoMC) simulation, by using the comonotonic approximation as a control variate. The CoMC is of broad applicability and numerical results show a remarkable speed improvement. We illustrate the method for estimating Tail Value-at-Risk and pricing basket options and Asian options when the logreturns follow a Black-Scholes model or a variance gamma model.

Keywords: control variate Monte Carlo, comonotonicity, option pricing, scientific computing

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867 Pricing European Options under Jump Diffusion Models with Fast L-stable Padé Scheme

Authors: Salah Alrabeei, Mohammad Yousuf

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The goal of option pricing theory is to help the investors to manage their money, enhance returns and control their financial future by theoretically valuing their options. Modeling option pricing by Black-School models with jumps guarantees to consider the market movement. However, only numerical methods can solve this model. Furthermore, not all the numerical methods are efficient to solve these models because they have nonsmoothing payoffs or discontinuous derivatives at the exercise price. In this paper, the exponential time differencing (ETD) method is applied for solving partial integrodifferential equations arising in pricing European options under Merton’s and Kou’s jump-diffusion models. Fast Fourier Transform (FFT) algorithm is used as a matrix-vector multiplication solver, which reduces the complexity from O(M2) into O(M logM). A partial fraction form of Pad`e schemes is used to overcome the complexity of inverting polynomial of matrices. These two tools guarantee to get efficient and accurate numerical solutions. We construct a parallel and easy to implement a version of the numerical scheme. Numerical experiments are given to show how fast and accurate is our scheme.

Keywords: Integral differential equations, , L-stable methods, pricing European options, Jump–diffusion model

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866 Pricing European Continuous-Installment Options under Regime-Switching Models

Authors: Saghar Heidari

Abstract:

In this paper, we study the valuation problem of European continuous-installment options under Markov-modulated models with a partial differential equation approach. Due to the opportunity for continuing or stopping to pay installments, the valuation problem under regime-switching models can be formulated as coupled partial differential equations (CPDE) with free boundary features. To value the installment options, we express the truncated CPDE as a linear complementarity problem (LCP), then a finite element method is proposed to solve the resulted variational inequality. Under some appropriate assumptions, we establish the stability of the method and illustrate some numerical results to examine the rate of convergence and accuracy of the proposed method for the pricing problem under the regime-switching model.

Keywords: continuous-installment option, European option, regime-switching model, finite element method

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865 Lie Symmetry Treatment for Pricing Options with Transactions Costs under the Fractional Black-Scholes Model

Authors: B. F. Nteumagne, E. Pindza, E. Mare

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We apply Lie symmetries analysis to price and hedge options in the fractional Brownian framework. The reputation of Lie groups is well spread in the area of Mathematical sciences and lately, in Finance. In the presence of transactions costs and under fractional Brownian motions, analytical solutions become difficult to obtain. Lie symmetries analysis allows us to simplify the problem and obtain new analytical solution. In this paper, we investigate the use of symmetries to reduce the partial differential equation obtained and obtain the analytical solution. We then proposed a hedging procedure and calibration technique for these types of options, and test the model on real market data. We show the robustness of our methodology by its application to the pricing of digital options.

Keywords: fractional brownian model, symmetry, transaction cost, option pricing

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864 Ethicality of Algorithmic Pricing and Consumers’ Resistance

Authors: Zainab Atia, Hongwei He, Panagiotis Sarantopoulos

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Over the past few years, firms have witnessed a massive increase in sophisticated algorithmic deployment, which has become quite pervasive in today’s modern society. With the wide availability of data for retailers, the ability to track consumers using algorithmic pricing has become an integral option in online platforms. As more companies are transforming their businesses and relying more on massive technological advancement, pricing algorithmic systems have brought attention and given rise to its wide adoption, with many accompanying benefits and challenges to be found within its usage. With the overall aim of increasing profits by organizations, algorithmic pricing is becoming a sound option by enabling suppliers to cut costs, allowing better services, improving efficiency and product availability, and enhancing overall consumer experiences. The adoption of algorithms in retail has been pioneered and widely used in literature across varied fields, including marketing, computer science, engineering, economics, and public policy. However, what is more, alarming today is the comprehensive understanding and focus of this technology and its associated ethical influence on consumers’ perceptions and behaviours. Indeed, due to algorithmic ethical concerns, consumers are found to be reluctant in some instances to share their personal data with retailers, which reduces their retention and leads to negative consumer outcomes in some instances. This, in its turn, raises the question of whether firms can still manifest the acceptance of such technologies by consumers while minimizing the ethical transgressions accompanied by their deployment. As recent modest research within the area of marketing and consumer behavior, the current research advances the literature on algorithmic pricing, pricing ethics, consumers’ perceptions, and price fairness literature. With its empirical focus, this paper aims to contribute to the literature by applying the distinction of the two common types of algorithmic pricing, dynamic and personalized, while measuring their relative effect on consumers’ behavioural outcomes. From a managerial perspective, this research offers significant implications that pertain to providing a better human-machine interactive environment (whether online or offline) to improve both businesses’ overall performance and consumers’ wellbeing. Therefore, by allowing more transparent pricing systems, businesses can harness their generated ethical strategies, which fosters consumers’ loyalty and extend their post-purchase behaviour. Thus, by defining the correct balance of pricing and right measures, whether using dynamic or personalized (or both), managers can hence approach consumers more ethically while taking their expectations and responses at a critical stance.

Keywords: algorithmic pricing, dynamic pricing, personalized pricing, price ethicality

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863 Hybrid Equity Warrants Pricing Formulation under Stochastic Dynamics

Authors: Teh Raihana Nazirah Roslan, Siti Zulaiha Ibrahim, Sharmila Karim

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A warrant is a financial contract that confers the right but not the obligation, to buy or sell a security at a certain price before expiration. The standard procedure to value equity warrants using call option pricing models such as the Black–Scholes model had been proven to contain many flaws, such as the assumption of constant interest rate and constant volatility. In fact, existing alternative models were found focusing more on demonstrating techniques for pricing, rather than empirical testing. Therefore, a mathematical model for pricing and analyzing equity warrants which comprises stochastic interest rate and stochastic volatility is essential to incorporate the dynamic relationships between the identified variables and illustrate the real market. Here, the aim is to develop dynamic pricing formulations for hybrid equity warrants by incorporating stochastic interest rates from the Cox-Ingersoll-Ross (CIR) model, along with stochastic volatility from the Heston model. The development of the model involves the derivations of stochastic differential equations that govern the model dynamics. The resulting equations which involve Cauchy problem and heat equations are then solved using partial differential equation approaches. The analytical pricing formulas obtained in this study comply with the form of analytical expressions embedded in the Black-Scholes model and other existing pricing models for equity warrants. This facilitates the practicality of this proposed formula for comparison purposes and further empirical study.

Keywords: Cox-Ingersoll-Ross model, equity warrants, Heston model, hybrid models, stochastic

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862 An Investigation for Information Asymmetry Nexus IPO Under-Pricing: A Case of Pakistan

Authors: Saqib Mehmood, Naveed Iqbal Chaudhry, Asif Mehmood

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This study intends to investigate the information asymmetry theories of IPO and under-pricing in Pakistan. The purpose of the study is to validate the information asymmetry about firm value which leads to under-pricing. A total of 55 IPOs listed from 2000-2011 were included in this study. OLS multiple regression was applied to achieve the objectives of this study. The findings of the study confirm the significance of information asymmetry on under-pricing in Pakistan. The findings have implications for issuing firms and prospective investors.

Keywords: information asymmetry, initial public offerings, under-pricing, firm value

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861 Predatory Pricing at Services Markets: Incentives, Mechanisms, Standards of Proving, and Remedies

Authors: Mykola G. Boichuk

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The paper concerns predatory pricing incentives and mechanisms in the markets of services, as well as its anti-competitive effects. As cost estimation at services markets is more complex in comparison to markets of goods, predatory pricing is more difficult to detect in the provision of services. For instance, this is often the case for professional services, which is analyzed in the paper. The special attention is given to employment markets as de-facto main supply markets for professional services markets. Also, the paper concerns such instances as travel agents' services, where predatory pricing may have implications not only on competition but on a wider range of public interest as well. Thus, the paper develops on effective ways to apply competition law rules on predatory pricing to the provision of services.

Keywords: employment markets, predatory pricing, services markets, unfair competition

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860 4G LTE Dynamic Pricing: The Drivers, Benefits, and Challenges

Authors: Ahmed Rashad Harb Riad Ismail

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The purpose of this research is to study the potential of Dynamic Pricing if deployed by mobile operators and analyse its effects from both operators and consumers side. Furthermore, to conclude, throughout the research study, the recommended conditions for successful Dynamic Pricing deployment, recommended factors identifying the type of markets where Dynamic Pricing can be effective, and proposal for a Dynamic Pricing stakeholders’ framework were presented. Currently, the mobile telecommunications industry is witnessing a dramatic growth rate in the data consumption, being fostered mainly by higher data speed technology as the 4G LTE and by the smart devices penetration rates. However, operators’ revenue from data services lags behind and is decupled from this data consumption growth. Pricing strategy is a key factor affecting this ecosystem. Since the introduction of the 4G LTE technology will increase the pace of data growth in multiples, consequently, if pricing strategies remain constant, then the revenue and usage gap will grow wider, risking the sustainability of the ecosystem. Therefore, this research study is focused on Dynamic Pricing for 4G LTE data services, researching the drivers, benefits and challenges of 4G LTE Dynamic Pricing and the feasibility of its deployment in practice from different perspectives including operators, regulators, consumers, and telecommunications equipment manufacturers point of views.

Keywords: LTE, dynamic pricing, EPC, research

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859 The Hidden Role of Interest Rate Risks in Carry Trades

Authors: Jingwen Shi, Qi Wu

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We study the role played interest rate risk in carry trade return in order to understand the forward premium puzzle. In this study, our goal is to investigate to what extent carry trade return is indeed due to compensation for risk taking and, more important, to reveal the nature of these risks. Using option data not only on exchange rates but also on interest rate swaps (swaptions), our first finding is that, besides the consensus currency risks, interest rate risks also contribute a non-negligible portion to the carry trade return. What strikes us is our second finding. We find that large downside risks of future exchange rate movements are, in fact, priced significantly in option market on interest rates. The role played by interest rate risk differs structurally from the currency risk. There is a unique premium associated with interest rate risk, though seemingly small in size, which compensates the tail risks, the left tail to be precise. On the technical front, our study relies on accurately retrieving implied distributions from currency options and interest rate swaptions simultaneously, especially the tail components of the two. For this purpose, our major modeling work is to build a new international asset pricing model where we use an orthogonal setup for pricing kernels and specify non-Gaussian dynamics in order to capture three sets of option skew accurately and consistently across currency options and interest rate swaptions, domestic and foreign, within one model. Our results open a door for studying forward premium anomaly through implied information from interest rate derivative market.

Keywords: carry trade, forward premium anomaly, FX option, interest rate swaption, implied volatility skew, uncovered interest rate parity

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858 Investigation on Cost Reflective Network Pricing and Modified Cost Reflective Network Pricing Methods for Transmission Service Charges

Authors: K. Iskandar, N. H. Radzi, R. Aziz, M. S. Kamaruddin, M. N. Abdullah, S. A. Jumaat

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Nowadays many developing countries have been undergoing a restructuring process in the power electricity industry. This process has involved disaggregating former state-owned monopoly utilities both vertically and horizontally and introduced competition. The restructuring process has been implemented by the Australian National Electricity Market (NEM) started from 13 December 1998, began operating as a wholesale market for supply of electricity to retailers and end-users in Queensland, New South Wales, the Australian Capital Territory, Victoria and South Australia. In this deregulated market, one of the important issues is the transmission pricing. Transmission pricing is a service that recovers existing and new cost of the transmission system. The regulation of the transmission pricing is important in determining whether the transmission service system is economically beneficial to both side of the users and utilities. Therefore, an efficient transmission pricing methodology plays an important role in the Australian NEM. In this paper, the transmission pricing methodologies that have been implemented by the Australian NEM which are the Cost Reflective Network Pricing (CRNP) and Modified Cost Reflective Network Pricing (MCRNP) methods are investigated for allocating the transmission service charges to the transmission users. A case study using 6-bus system is used in order to identify the best method that reflects a fair and equitable transmission service charge.

Keywords: cost-reflective network pricing method, modified cost-reflective network pricing method, restructuring process, transmission pricing

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857 Price Setting and the Role of Accounting Information

Authors: Chris Durden, Peter Lane

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Cost accounting information potentially plays an important role in price setting. According to prior research fixed and variable cost information often is a key influence on pricing decisions. The literature highlights the benefits of applying systematic costing systems for enhanced price setting processes. This paper explores how costing systems are used for pricing decisions in the tourism and hospitality industry relative to other sources of price setting information. Pricing based on full cost information was found to have relatively greater importance and short-term survival and customer oriented objectives were found to be the more important pricing objectives. This paper contributes to the literature by providing a recent analysis of accounting’s role in price setting within the tourism and hospitality industry.

Keywords: cost accounting systems, pricing decisions, cost-plus pricing, market pricing, tourism industry

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856 Potentials and Influencing Factors of Dynamic Pricing in Business: Empirical Insights of European Experts

Authors: Christopher Reichstein, Ralf-Christian Härting, Martina Häußler

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With a continuously increasing speed of information exchange on the World Wide Web, retailers in the E-Commerce sector are faced with immense possibilities regarding different online purchase processes like dynamic price settings. By use of Dynamic Pricing, retailers are able to set short time price changes in order to optimize producer surplus. The empirical research illustrates the basics of Dynamic Pricing and identifies six influencing factors of Dynamic Pricing. The results of a structural equation modeling approach show five main drivers increasing the potential of dynamic price settings in the E-Commerce. Influencing factors are the knowledge of customers’ individual willingness to pay, rising sales, the possibility of customization, the data volume and the information about competitors’ pricing strategy.

Keywords: e-commerce, empirical research, experts, dynamic pricing (DP), influencing factors, potentials

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855 A Generalization of Option Pricing with Discrete Dividends to Markets with Daily Price Limits

Authors: Jiahau Guo, Yihe Zhang

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This paper proposes solutions for pricing options on stocks paying discrete dividends in markets with daily price limits. We first extend the intraday density function of Guo and Chang (2020) to a multi-day one and use the framework of Haug et al. (2003) to value European options on stocks paying discrete dividends. Next, we adopt the fast Fourier transform (FFT) to derive accurate and efficient formulae for American options and further employ the three-point Richardson extrapolation to accelerate the computation. Finally, the accuracy of our proposed methods is verified by simulations.

Keywords: daily price limit, discrete dividend, early exercise, fast Fourier transform, multi-day density function, Richardson extrapolation

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854 Investigating the Effective Parameters in Determining the Type of Traffic Congestion Pricing Schemes in Urban Streets

Authors: Saeed Sayyad Hagh Shomar

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Traffic congestion pricing – as a strategy in travel demand management in urban areas to reduce traffic congestion, air pollution and noise pollution – has drawn many attentions towards itself. Unlike the satisfying findings in this method, there are still problems in determining the best functional congestion pricing scheme with regard to the situation. The so-called problems in this process will result in further complications and even the scheme failure. That is why having proper knowledge of the significance of congestion pricing schemes and the effective factors in choosing them can lead to the success of this strategy. In this study, first, a variety of traffic congestion pricing schemes and their components are introduced; then, their functional usage is discussed. Next, by analyzing and comparing the barriers, limitations and advantages, the selection criteria of pricing schemes are described. The results, accordingly, show that the selection of the best scheme depends on various parameters. Finally, based on examining the effective parameters, it is concluded that the implementation of area-based schemes (cordon and zonal) has been more successful in non-diversion of traffic. That is considering the topology of the cities and the fact that traffic congestion is often created in the city centers, area-based schemes would be notably functional and appropriate.

Keywords: congestion pricing, demand management, flat toll, variable toll

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853 A Theoretical Framework of Multifactor Systematic Risks in Equity Market: Behavioral Finance Paradigm

Authors: Jasman Tuyon, Zamri Ahmad

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Behavioral asset pricing research has been gaining momentum since in 1990s. However, it is still incomplete and has been criticized for some philosophical, theoretical and model specification limitations. Due to these drawbacks, investors’ behaviors as a source of risk in behavioral asset pricing modeling still remains disputable. This paper aims to address these issues with an alternative perspective based on behavioral finance paradigm. Specifically, this paper proposes a theoretical linkages of both fundamental and behavioral risks on stock prices formation and an extension of the multifactor stock pricing model by combining multi-factor fundamentals and behavioral risks factors.

Keywords: behavioral finance, multifactor asset pricing, behavioral risks, fundamental risks

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852 Combining a Continuum of Hidden Regimes and a Heteroskedastic Three-Factor Model in Option Pricing

Authors: Rachid Belhachemi, Pierre Rostan, Alexandra Rostan

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This paper develops a discrete-time option pricing model for index options. The model consists of two key ingredients. First, daily stock return innovations are driven by a continuous hidden threshold mixed skew-normal (HTSN) distribution which generates conditional non-normality that is needed to fit daily index return. The most important feature of the HTSN is the inclusion of a latent state variable with a continuum of states, unlike the traditional mixture distributions where the state variable is discrete with little number of states. The HTSN distribution belongs to the class of univariate probability distributions where parameters of the distribution capture the dependence between the variable of interest and the continuous latent state variable (the regime). The distribution has an interpretation in terms of a mixture distribution with time-varying mixing probabilities. It has been shown empirically that this distribution outperforms its main competitor, the mixed normal (MN) distribution, in terms of capturing the stylized facts known for stock returns, namely, volatility clustering, leverage effect, skewness, kurtosis and regime dependence. Second, heteroscedasticity in the model is captured by a threeexogenous-factor GARCH model (GARCHX), where the factors are taken from the principal components analysis of various world indices and presents an application to option pricing. The factors of the GARCHX model are extracted from a matrix of world indices applying principal component analysis (PCA). The empirically determined factors are uncorrelated and represent truly different common components driving the returns. Both factors and the eight parameters inherent to the HTSN distribution aim at capturing the impact of the state of the economy on price levels since distribution parameters have economic interpretations in terms of conditional volatilities and correlations of the returns with the hidden continuous state. The PCA identifies statistically independent factors affecting the random evolution of a given pool of assets -in our paper a pool of international stock indices- and sorting them by order of relative importance. The PCA computes a historical cross asset covariance matrix and identifies principal components representing independent factors. In our paper, factors are used to calibrate the HTSN-GARCHX model and are ultimately responsible for the nature of the distribution of random variables being generated. We benchmark our model to the MN-GARCHX model following the same PCA methodology and the standard Black-Scholes model. We show that our model outperforms the benchmark in terms of RMSE in dollar losses for put and call options, which in turn outperforms the analytical Black-Scholes by capturing the stylized facts known for index returns, namely, volatility clustering, leverage effect, skewness, kurtosis and regime dependence.

Keywords: continuous hidden threshold, factor models, GARCHX models, option pricing, risk-premium

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851 Numerical Methods versus Bjerksund and Stensland Approximations for American Options Pricing

Authors: Marasovic Branka, Aljinovic Zdravka, Poklepovic Tea

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Numerical methods like binomial and trinomial trees and finite difference methods can be used to price a wide range of options contracts for which there are no known analytical solutions. American options are the most famous of that kind of options. Besides numerical methods, American options can be valued with the approximation formulas, like Bjerksund-Stensland formulas from 1993 and 2002. When the value of American option is approximated by Bjerksund-Stensland formulas, the computer time spent to carry out that calculation is very short. The computer time spent using numerical methods can vary from less than one second to several minutes or even hours. However to be able to conduct a comparative analysis of numerical methods and Bjerksund-Stensland formulas, we will limit computer calculation time of numerical method to less than one second. Therefore, we ask the question: Which method will be most accurate at nearly the same computer calculation time?

Keywords: Bjerksund and Stensland approximations, computational analysis, finance, options pricing, numerical methods

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850 Model-Independent Price Bounds for the Swiss Re Mortality Bond 2003

Authors: Raj Kumari Bahl, Sotirios Sabanis

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In this paper, we are concerned with the valuation of the first Catastrophic Mortality Bond that was launched in the market namely the Swiss Re Mortality Bond 2003. This bond encapsulates the behavior of a well-defined mortality index to generate payoffs for the bondholders. Pricing this bond is a challenging task. We adapt the payoff of the terminal principal of the bond in terms of the payoff of an Asian put option and present an approach to derive model-independent bounds exploiting comonotonic theory. We invoke Jensen’s inequality for the computation of lower bounds and employ Lagrange optimization technique to achieve the upper bound. The success of these bounds is based on the availability of compatible European mortality options in the market. We carry out Monte Carlo simulations to estimate the bond price and illustrate the strength of these bounds across a variety of models. The fact that our bounds are model-independent is a crucial breakthrough in the pricing of catastrophic mortality bonds.

Keywords: mortality bond, Swiss Re Bond, mortality index, comonotonicity

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849 Dynamic Pricing With Demand Response Managment in Smart Grid: Stackelberg Game Approach

Authors: Hasibe Berfu Demi̇r, Şakir Esnaf

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In the past decade, extensive improvements have been done in electrical grid infrastructures. It is very important to make plans on supply, demand, transmission, distribution and pricing for the development of the electricity energy sector. Based on this perspective, in this study, Stackelberg game approach is proposed for demand participation management (DRM), which has become an important component in the smart grid to effectively reduce power generation costs and user bills. The purpose of this study is to examine electricity consumption from a dynamic pricing perspective. The results obtained were compared with the current situation and the results were interpreted.

Keywords: lectricity, stackelberg, smart grid, demand response managment, dynamic pricing

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848 Optimal Pricing Mechanism for Non-Storable Goods: The Power of Opaque Products

Authors: Juana M. Alonso, M. Pilar Socorro

Abstract:

In this paper, we develop a theoretical model to analyze firms’ optimal pricing mechanism for non-storable goods. With non-storable goods, firms may be interested in introducing opaque products in order to have two different markets: the transparent market and the opaque market. This may allow firms to sell all their non-storable goods, discriminate prices between markets, and maximize revenues. We prove that in a situation of low demand in the transparent market, if all consumers are risk neutral or risk loving, introducing opaque products is always the most profitable strategy for the firm. However, if consumers are risk averse, the firm needs to offer opaque products with an additional discount. We analyze under which circumstances selling opaque products with such a discount is the optimal pricing strategy. Throughout the paper, we use airlines’ pricing strategy as an application for non-storable goods (flights), opaque products (blind tickets), and continuously changing demand (as it is nowadays the case in the air transport industry due to the Covid-19 pandemic).

Keywords: opaque products, risk attitude, expected utility, pricing strategy

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