AN ALTERNATIVE VALUATION MODEL FOR CONTINGENT CLAIMS

This paper studies contingent claim valuation in a Lucas-type exchange economy. The derived fundamental valuation equation differs from its Cox-Ingersoll-Ross production-economy counterpart in that it is expres sed in terms of the direct utility function and an exogenous output pr ocess, thus offering superior tractability. We apply our approach to d erive closed-form solutions for bond, bond option, individual stock, a nd stock option prices, under a more general setting than allowable in the Cox-Ingersoll-Ross framework. The resulting interest rate and sto ck price dynamics are empirically plausible. Moreover, our stock optio n pricing formula with stochastic volatility and interest rates can re concile certain puzzling empirical regularities, including the volatil ity smile.