Rational hedging and valuation of integrated risks under constant absolute risk aversion

We study a rational valuation and hedging principle for contingent claims which integrate tradable and non-tradable sources of risk. The principle is based on the preferences of a rational investor with constant absolute risk aversion, and uses exponential utility-indifference arguments. Properties of this valuation and of a corresponding hedging strategy are analyzed in a general semi-martingale market framework. To obtain further constructive results and properties, a more specific class of semi-complete product models is studied in detail. This yields a computation scheme, simple valuation bounds, and results on diversification and information effects. (C) 2003 Elsevier Science B.V. All rights reserved.