Model misspecification and pricing of illiquid claims

This paper analyses the impact of model misspecification on pricing and hedging of illiquid claims. We consider the case when an ambiguous investor hedges his position in an illiquid claim, written on a nontraded asset, by investing in a tradable asset. The optimal trading strategy and utility indifference price of the claim are derived. It is shown that when the model for the underlying asset is misspecified, the utility indifference price is not necessarily increasing or decreasing in the correlation between traded and nontraded assets. An explanation for the puzzle of why small retail investors buy structured bonds is given.