Utility-based valuation and hedging of basis risk with partial information

We analyse the valuation and hedging of a claim on a non-traded asset using a correlated traded asset under a partial information scenario, when the asset drifts are unknown constants. Using a Kalman filter and a Gaussian prior distribution for the unknown parameters, a full information model with random drifts is obtained. This is subjected to exponential indifference valuation. An expression for the optimal hedging strategy is derived. An asymptotic expansion for small values of risk aversion is obtained via partial differentiation equation (PDE) methods, following on from payoff decompositions and a price representation equation. Analytic and semi- analytic formulae for the terms in the expansion are obtained when the minimal entropy measure coincides with the minimal martingale measure. Simulation experiments are carried out which indicate that the filtering procedure can be beneficial in hedging, but sometimes needs to be augmented with the increased option premium, which takes into account parameter uncertainty in order to be effective. Empirical examples are presented which conform to these conclusions. © 2010 Taylor and Francis