Spanning and derivative-security valuation

This article provides the economic foundations for valuing derivative secur ities. In particular, it establishes how the characteristic function (of th e future uncertainty) is basis augmenting and spans the payoff universe of most, if not all, derivative assets. From the characteristic function of th e state-price density, it is possible to analytically price options on any arbitrary transformation of the underlying uncertainty. By differentiating (or translating) the characteristic function, limitless pricing and/or span ning opportunities can be designed. The strength and versatility of the met hodology is inherent when valuing (1) average-interest options, (2) correla tion options, and (3) discretely monitored knock-out options. (C) 2000 Else vier Science S.A, All rights reserved. JEL classification: CIO; G12; G13.