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Hedging Under an Expected Loss Constraint with Small Transaction Costs

Author

Listed:
  • Bruno BOUCHARD

    (Université de Paris Dauphine and CREST-ENSAE)

  • Ludovic MOREAU

    (ETH Zurich)

  • Mete SONER

    (ETH Zurich and Swiss Finance Institute)

Abstract

We consider the problem of option hedging in a market with proportional transaction costs. Since super-replication is very costly in such markets, we replace perfect hedging with an expected loss constraint. Asymptotic analysis for small transaction costs is used to obtain a tractable model. A general expansion theory is developed using the dynamic programming approach. Explicit formulae are obtained in the special cases of exponential and power utility functions. As a corollary, we retrieve the asymptotics for the exponential utility indifference price.

Suggested Citation

  • Bruno BOUCHARD & Ludovic MOREAU & Mete SONER, 2014. "Hedging Under an Expected Loss Constraint with Small Transaction Costs," Swiss Finance Institute Research Paper Series 14-60, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1460
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    File URL: http://ssrn.com/abstract=2512205
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    More about this item

    Keywords

    Expected loss constraint; hedging; transaction cost; asymptotic expansion;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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