Interest rate risk premium and equity valuation

Abstract

The authors employ the recent stochastic-control-based approach to financial mathematics to solve a problem of determination of the risk premium for a stochastic interest rate model, and the corresponding problem of equity valuation. The risk premium is determined explicitly, by means of solving a corresponding partial differential equation (PDE), in two forms: one, time-dependent, corresponding to a finite time contract expiration, and the simpler version corresponding to perpetual contracts. As stocks are perpetual contracts, when solving the problem of equity valuation, the latter form of the risk premium is used. By means of solving the general pricing PDE, an efficient equity valuation method was developed that is a combination of some sophisticated explicit formulas, and a numerical procedure.