Utility Indifference Valuation (Compensating Variations)

Under market frictions like illiquidity or transaction costs, contingent claims can incorporate some inevitable intrinsic risk that cannot be completely hedged away but remains with the holder. In general, they cannot be synthesized by dynamical trading in liquid assets and hence not be priced by no-arbitrage arguments alone. Still, an agent can determine a valuation with respect to her preferences towards risk. The utility indifference value for a variation in the quantity of illiquid assets held by the agent is defined as the compensating variation of wealth, under which her maximal expected utility remains unchanged.