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The Valuation Model for a Risky Asset When Its Risky Factors Follow Gamma Distributions
Author(s) -
Tsai Ming Shann,
Chiang Shu Ling
Publication year - 2016
Publication title -
international review of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.489
H-Index - 18
eISSN - 1468-2443
pISSN - 1369-412X
DOI - 10.1111/irfi.12088
Subject(s) - econometrics , valuation (finance) , gamma distribution , bond , actuarial science , capital asset pricing model , asset (computer security) , economics , computer science , mathematics , statistics , finance , computer security
This paper constructed a pricing model for the asset with multi‐risks by specifying the risky factors (i.e., interest rate and termination hazard rates) to follow gamma distributions. The model not only avoids the possibility of the termination hazard rate taking an irrational (i.e., negative) value, but it also makes it easier to derive a valuation formula for a risky asset. Our model can also effortless apply because the parameters of the gamma distribution can easily be estimated from market data. An example using Taiwanese bond data illustrates how the model can be utilized for practical applications. To facilitate understanding of how accurately the different models price risky bonds, we compare their out‐of‐sample pricing errors for different hazard rate specifications assuming normal and gamma distributions. The results show that our pricing formula is realistic and accurate in its applications. Therefore, it should help market participants to accurately price risky assets and to effectively manage complicated portfolios.