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European Option Pricing and Hedging with both Fixed and Proportional Transaction Costs

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  • Valeri Zakamouline

    (Norwegian School of Economics & Business Administration)

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    Abstract

    In this paper we extend the utility based option pricing and hedging approach, pioneered by Hodges and Neuberger (1989) and further developed by Davis, Panas and Zariphopoulou (1993), for the market where each transaction has a fixed cost component. We present a model, where investors have a CARA utility, and derive some properties of reservation option prices. We suggest and implement discretization schemes for computing the reservation option prices. The numerical results of option pricing and hedging are presented for the case of European call options and the investors with different levels of ARA. We also try to reconcile our findings with such empirical pricing bias as the volatility smile.

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    File URL: http://128.118.178.162/eps/fin/papers/0311/0311009.pdf
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    Bibliographic Info

    Paper provided by EconWPA in its series Finance with number 0311009.

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    Length: 43 pages
    Date of creation: 21 Nov 2003
    Date of revision:
    Handle: RePEc:wpa:wuwpfi:0311009

    Note: Type of Document - pdf; prepared on WinXP; pages: 43; figures: 6
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    Web page: http://128.118.178.162

    Related research

    Keywords: option pricing; transaction costs; stochastic control; Markov chain approximation;

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    1. Dermody, Jaime Cuevas & Prisman, Eliezer Z., 1993. "No Arbitrage and Valuation in Markets with Realistic Transaction Costs," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(01), pages 65-80, March.
    2. George M. Constantinides & Thaleia Zariphopoulou, . "Bounds on Prices of Contingent Claims in an Intertemporal Economy with Proportional Transaction Costs and General Preferences," CRSP working papers 347, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    4. Benjamin Mohamed, 1994. "Simulations of transaction costs and optimal rehedging," Applied Mathematical Finance, Taylor & Francis Journals, vol. 1(1), pages 49-62.
    5. A. E. Whalley & P. Wilmott, 1997. "An Asymptotic Analysis of an Optimal Hedging Model for Option Pricing with Transaction Costs," Mathematical Finance, Wiley Blackwell, vol. 7(3), pages 307-324.
    6. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
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