Approximate indifference pricing in exponential Lévy models

Financial markets based on Lévy processes are typically incomplete and option prices depend on risk attitudes of individual agents. In this context, the notion of utility indifference price has gained popularity in the academic circles. Although theoretically very appealing, this pricing method remains difficult to apply in practice, due to the high computational cost of solving the non-linear partial integro-differential equation associated to the indifference price. In this work, we develop closed-form approximations to exponential utility indifference prices in exponential Lévy models. To this end, we first establish a new non-asymptotic approximation of the indifference price which extends earlier results on small risk aversion asymptotics of this quantity. Next, we use this formula to derive a closed-form approximation of the indifference price by treating the Lévy model as a perturbation of the Black–Scholes model. This extends the methodology introduced in a recent paper for smooth linear functionals of Lévy processes (Černý et al. 2013) to non-linear and non-smooth functionals. Our formula represents the indifference price as the linear combination of the Black–Scholes price and correction terms which depend on the variance, skewness and kurtosis of the underlying Lévy process, and the derivatives of the Black–Scholes price. As a by-product, we obtain a simple approximation for the spread between the buyer’s and the seller’s indifference price. This formula allows to quantify, in a model-independent fashion, how sensitive a given product is to jump risk when jump size is small.