Indifference pricing is a pricing paradigm based on the concept of utility indifference. For a trader who takes decisions that maximise a utility function, the indifference price maximises the utility in the presence of the trade, while maximising the trader’s utility in the absence of the trade. In other words, at the indifference price the trader has no preference on whether to trade or not.
Indifference pricing was developed in 1989 by Stewart Hodges and Anthony Neuberger and has been expanded thereafter, especially in academia. It is often employed to price securities in incomplete markets, where traditional risk-neutral valuation fails because the number of traded assets is insufficient to build a replicating portfolio.
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