A fast numerical algorithm is developed to price European options with proportional transaction costs using the utility maximization framework of Davis (1997). This approach allows option prices to be computed by solving the investor's basic portfolio selection problem, without the insertion of the option payoff into the terminal value function. The properties of the value function can then be used to drastically reduce the number of operations needed to locate the boundaries of the no transaction region, which leads to very efficient option valuation. The optimization problem is solved numerically for the case of exponential utility, and comparisons with approximately replicating strategies reveal tight bounds for option prices even as transaction costs become large. The computational technique involves a discrete time Markov chain approximation to a continuous time singular stochastic optimal control problem. A general de nition of an option hedging strategy in this framework is developed. This involves calculating the perturbation to the optimal portfolio strategy when an option trade is executed.
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. In case of further problems read
the IDEAS help
page. Note that these files are not on the IDEAS
site. Please be patient as the files may be large.
Publisher Info
Paper provided by Economics and Finance Section, School of Social Sciences, Brunel University in its series Public Policy Discussion Papers with number
02-22.
Length: 23 pages Date of creation: Jul 2002 Date of revision: Handle: RePEc:bru:bruppp:02-22
Contact details of provider: Postal: Brunel University, Uxbridge, Middlesex UB8 3PH, UK
For technical questions regarding this item, or to correct its listing, contact: (John.Hunter).
Related research
Keywords:
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.: