Displaced Diffusion Option Pricing with Two Risky Assets

Abstract

Firms usually hold several assets and liabilities that are not tradable separately, but tradable in aggregation as the firm’s equity, as first modeled by Rubinstein (1983) in his well-known displaced diffusion option pricing model with one risky and one riskless asset. When the Rubinstein model is extended to a firm with two risky assets, the standard riskless hedge argument cannot justify that the options on the firm’s equity can be priced by the risk-neutral valuation, because the two assets are not separately tradable. However, this paper shows that the aggregate tradability is likely to be sufficient for supporting the risk neutral option valuation.