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Simulations of transaction costs and optimal rehedging

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  • Benjamin Mohamed
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    Abstract

    This paper addresses the issue of hedging options under proportional transaction costs. The Black-Scholes environment assumes frictionless markets in which one can replicate the option payoff exactly by continuous rehedging. However, when transaction costs are involved, frequent rehedging results in the accumulation of transaction costs. Conversely, infrequent hedging results in replication errors. This document attempts to evaluate several rehedging strategies by Monte Carlo simulations. The simulations are constructed so that hedging errors and transaction costs are separated permitting the relative trade-offs to be inspected. Results show that an analytic approximation to a utility maximization approach is both effective and simple to implement. The strategy results in the requirement to hedge to within a dynamic band around the Black-Scholes delta. The band is a function of the option's gamma.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/13504869400000003
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Applied Mathematical Finance.

    Volume (Year): 1 (1994)
    Issue (Month): 1 ()
    Pages: 49-62

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    Handle: RePEc:taf:apmtfi:v:1:y:1994:i:1:p:49-62

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    Web page: http://www.tandfonline.com/RAMF20

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    Related research

    Keywords: options; transaction costs; hedging;

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    Cited by:
    1. Valeri Zakamouline, 2003. "European Option Pricing and Hedging with both Fixed and Proportional Transaction Costs," Finance 0311009, EconWPA.
    2. Zakamouline, Valeri I., 2006. "European option pricing and hedging with both fixed and proportional transaction costs," Journal of Economic Dynamics and Control, Elsevier, vol. 30(1), pages 1-25, January.
    3. Naio Ino & Afonso De Campos Pint, 2014. "Delta Hedge Com Custos Detransação: Uma Análise Comparativa," Anais do XLI Encontro Nacional de Economia [Proceedings of the 41th Brazilian Economics Meeting] 143, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].
    4. Lai, Tze Leung & Lim, Tiong Wee, 2009. "Option hedging theory under transaction costs," Journal of Economic Dynamics and Control, Elsevier, vol. 33(12), pages 1945-1961, December.

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