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Option valuation with liquidity risk and jumps

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  • Hai Zhang
  • Hyejin Ku

Abstract

This article provides a simple model for pricing and hedging options in the presence of jumps and liquidity costs. In the article, liquidity risk is modelled via a stochastic supply curve function and a jump-diffusion process is approximated by a Markov chain. Local risk minimization incorporating liquidity risk is proposed to price and hedge European options in this discrete-time model. Moreover, an example is provided to implement the modified risk minimization method and to demonstrate the performance of hedging strategies.

Suggested Citation

  • Hai Zhang & Hyejin Ku, 2018. "Option valuation with liquidity risk and jumps," Applied Economics Letters, Taylor & Francis Journals, vol. 25(6), pages 381-387, March.
    • Handle: RePEc:taf:apeclt:v:25:y:2018:i:6:p:381-387
    DOI: 10.1080/13504851.2017.1324606
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