Discrete time linear-quadratic pricing of bonds and options

This article presents a discrete time pricing model whereby prices are either exponential linear-quadratic functions of stochastic factors or transforms of such exponential linear-quadratic functions. The model is applied to price default-free bonds and stock options under stochastic volatility and is the discrete time counterpart of the continuous time Linear Quadratic (LQ) model of Cheng and Scaillet (2007). In discrete time, the factors are conditionally Gaussian and market prices of risk can be specified with much freedom.