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Sufficient conditions of stochastic dominance for general transformations and its application in option strategy

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  • Gao, Jianwei
  • Zhao, Feng

Abstract

A counterexample is presented to show that the sufficient condition for one transformation dominating another by the second degree stochastic dominance, proposed by Theorem 5 of Levy (Stochastic dominance and expected utility: Survey and analysis, 1992), does not hold. Then, by restricting the monotone property of the dominating transformation, a revised exact sufficient condition for one transformation dominating another is given. Next, the stochastic dominance criteria, proposed by Meyer (Stochastic Dominance and transformations of random variables, 1989) and developed by Levy (Stochastic dominance and expected utility: Survey and analysis, 1992), are extended to the most general transformations. Moreover, such criteria are further generalized to transformations on discrete random variables. Finally, the authors employ this method to analyze the transformations resulting from holding a stock with the corresponding call option.

Suggested Citation

  • Gao, Jianwei & Zhao, Feng, 2017. "Sufficient conditions of stochastic dominance for general transformations and its application in option strategy," Economics Discussion Papers 2017-40, Kiel Institute for the World Economy (IfW Kiel).
    • Handle: RePEc:zbw:ifwedp:201740
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    References listed on IDEAS

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    More about this item

    Keywords

    stochastic dominance; transformation; utility theory; option strategy;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G1 - Financial Economics - - General Financial Markets

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