Pricing and Hedging Options in Incomplete Markets: Idiosyncratic Risk, Systematic Risk and Stochastic Volatility

Abstract

Starting from the European option valuation framework of Chauveau & Gatfaoui (2002), we establish the link with stochastic volatility models. And, we propose both a new vision and a general framework for valuing European options in the light of systematic and idiosyncratic risks affecting risky assets in the financial market. Therefore, we account for the well-known volatility smile in the light of the literature addressing the determinants of the smile effect among which stochastic volatility and market risk. We further discuss briefly the hedging of European options along with the local risk minimization principle. Specifically, we attempt to find a strategy, which dominates the usual partial hedging technique often imposed by market’s incompleteness.Call pricing, idiosyncratic risk, incomplete market, stochastic volatility, systematic risk.