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Optimal Hedging of Options with Small but Arbitrary Transaction Cost Structure

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  • A.E. Whalley
  • P. Wilmott
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    Abstract

    In this paper we consider the problem of hedging options in the presence of costs in trading the underlying asset. This work is an asymptotic analysis of a stochastic control problem, as in Hodges & Neuberger (1989) and Davis, Panas & Zariphopoulou (1993) . We derive a simple expression for the `hedging bandwidth' around the Black-Scholes delta; this is the region in which it is optimal not to rehedge. The effect of the costs on the value of the option, and on the width of this hedging band is of a significantly greater order of magnitude than the costs themselves. When costs are proportional to volume traded, rehedging should be done to the edge of this band; when there are fixed costs present, trading should be done to an optimal point in the interior of the no-transaction region.

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    Bibliographic Info

    Paper provided by Oxford Financial Research Centre in its series OFRC Working Papers Series with number 1999mf09.

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    Date of creation: 1999
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    Handle: RePEc:sbs:wpsefe:1999mf09

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    Web page: http://www.finance.ox.ac.uk
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    Cited by:
    1. Naoyuki Ishimura, 2010. "Remarks on the Nonlinear Black-Scholes Equations with the Effect of Transaction Costs," Asia-Pacific Financial Markets, Springer, vol. 17(3), pages 241-259, September.
    2. Hitoshi Imai & Naoyuki Ishimura & Ikumi Mottate & Masaaki Nakamura, 2006. "On the Hoggard–Whalley–Wilmott Equation for the Pricing of Options with Transaction Costs," Asia-Pacific Financial Markets, Springer, vol. 13(4), pages 315-326, December.
    3. Masaaki Fukasawa, 2014. "Efficient discretization of stochastic integrals," Finance and Stochastics, Springer, vol. 18(1), pages 175-208, January.

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