We examine the nature of some well-known phenomena such as volatility smiles, convexity adjustments and parallel  markets. We propose that the market is incomplete and postulate the existence of an intrinsic risk in every contingent claim as a basis for understanding the phenomena. In a continuous time framework, we bring together the notion of intrinsic risk and the theory of change of measures to derive a probability measure, namely risk-subjective measure, for pricing and hedging financial derivatives. The risk-subjective measure and the measure of intrinsic risk provide an internal consistency in pricing and hedging contingent claims and importantly explains the phenomena .
We examine the nature of some well-known phenomena such as volatility smiles, convexity adjustments and parallel derivative markets. We propose that the market is incomplete and postulate the existence of an intrinsic risk in every contingent claim as a basis for understanding these phenomena. In a continuous time framework, we bring together the notion of intrinsic risk and the theory of change of measures to derive a probability measure, namely risk-subjective measure, for evaluating contingent claims. This paper is a modest attempt to prove that measure of intrinsic risk is a crucial ingredient for explaining these phenomena, and in consequence proposes a new approach to pricing and hedging financial derivatives. We show that our approach is consistent and robust, compared with the standard risk-neutral approach .
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