Abstract
Pricing a contingent claim on a non-tradable asset (e.g. a management warrant package in an LBO) cannot be done with standard hedging based option pricing theory. Common alternatives are utility indifference pricing, suggested by various authors, or risk premium pricing (using the option pricing methodology with the asset drift modified for a risk premium), often favored by practitioners. The purpose of this note is to point out that the two approaches are in fact conceptually equivalent, in the sense that the utility function risk aversion in the first method can be mapped into a risk premium in the second method.
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