Stochastic Discount Factor-Based Approach for Warrant Pricing

By applying the stochastic discount factor methodology,the problem of warrant pricing when the underlying asset follows the stochastic volatility model with leverage effect(SV-L) is considered in this paper.First,the stochastic discount factor is specified as an exponential-affine function of the state variable,which corresponds to an Esscher transform used in actuarial.Based on this exponential-affine specification of the stochastic discount factor,economically consistent and unique price is given for a warrant in incomplete market.Then,the risk-neutral dynamics of the underlying asset return is derived by combining the exponential-affine specification of the stochastic discount factor with the SV-L model.Finally,an empirical study of call warrants for trading on Shanghai and Shenzhen stock exchanges is presented.Empirical results show that the proposed warrant pricing model is more accurate than the classical Black-Scholes(B-S) model.