Abstract
We present a new approach for dynamic pricing of infrastructure investment projects with stochastic cash flow streams. In our framework, projects are viewed as options in an incomplete market, whose prices are determined by a stochastic discount factor (SDF) reflecting an option writer/buyer's aversion to “basis risks”. We first formulate a “regularized inverse problem” that estimates a unique arbitrage-free SDF from observed asset prices. We then show that the problem is equivalent to a dynamic risk control (hedging) problem with CARA utility. Our analysis further reveals that ask/bid price of an option significantly depends on the correlation between option pay-off and asset prices traded in security markets.
