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Option Pricing And Hedging With Execution Costs And Market Impact

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  • Olivier Guéant
  • Jiang Pu

Abstract

In this article we consider the pricing and (partial) hedging of a call option when liquidity matters, that is either for a large nominal or for an illiquid underlying. In practice, as opposed to the classical assumptions of a price-taker agent in a frictionless market, traders cannot be perfectly hedged because of execution costs and market impact. They face indeed a trade-off between mishedge errors and hedging costs that can be solved using stochastic optimal control. Our framework is inspired from the recent literature on optimal execution and permits to account for both execution costs and the lasting market impact of our trades. Prices are obtained through the indifference pricing approach and not through super-replication. Numerical examples are provided using PDEs, along with comparison with the Black model.
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Suggested Citation

  • Olivier Guéant & Jiang Pu, 2017. "Option Pricing And Hedging With Execution Costs And Market Impact," Mathematical Finance, Wiley Blackwell, vol. 27(3), pages 803-831, July.
    • Handle: RePEc:bla:mathfi:v:27:y:2017:i:3:p:803-831
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    File URL: http://hdl.handle.net/10.1111/mafi.2017.27.issue-3
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    Cited by:

    1. Ibrahim Ekren & Sergey Nadtochiy, 2022. "Utility‐based pricing and hedging of contingent claims in Almgren‐Chriss model with temporary price impact," Mathematical Finance, Wiley Blackwell, vol. 32(1), pages 172-225, January.
    2. Francesco Mandelli & Marco Pinciroli & Michele Trapletti & Edoardo Vittori, 2023. "Reinforcement Learning for Credit Index Option Hedging," Papers 2307.09844, arXiv.org.
    3. Héctor Jasso-Fuentes & Carlos G. Pacheco & Gladys D. Salgado-Suárez, 2023. "A discrete-time optimal execution problem with market prices subject to random environments," TOP: An Official Journal of the Spanish Society of Statistics and Operations Research, Springer;Sociedad de Estadística e Investigación Operativa, vol. 31(3), pages 562-583, October.
    4. Ibrahim Ekren & Johannes Muhle-Karbe, 2017. "Portfolio Choice with Small Temporary and Transient Price Impact," Papers 1705.00672, arXiv.org, revised Apr 2020.
    5. Ibrahim Ekren & Sergey Nadtochiy, 2019. "Utility-based pricing and hedging of contingent claims in Almgren-Chriss model with temporary price impact," Papers 1910.01778, arXiv.org, revised Jun 2020.
    6. Hugo E. Ramirez & Peter Duck & Paul V. Johnson & Sydney Howell, 2019. "Hedge-Fund Management With Liquidity Constraint," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(06), pages 1-31, September.
    7. Masaaki Fukasawa & Mitja Stadje, 2017. "Perfect hedging under endogenous permanent market impacts," Papers 1702.01385, arXiv.org.
    8. Peter Bank & Mete Soner & Moritz Vo{ss}, 2015. "Hedging with Temporary Price Impact," Papers 1510.03223, arXiv.org, revised Jul 2016.
    9. David Evangelista & Yuri Thamsten, 2023. "Approximately optimal trade execution strategies under fast mean-reversion," Papers 2307.07024, arXiv.org, revised Aug 2023.
    10. Anderegg, Benjamin & Ulmann, Florian & Sornette, Didier, 2022. "The impact of option hedging on the spot market volatility," Journal of International Money and Finance, Elsevier, vol. 124(C).
    11. Qing-Qing Yang & Wai-Ki Ching & Jiawen Gu & Tak-Kuen Siu, 2020. "Trading strategy with stochastic volatility in a limit order book market," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 43(1), pages 277-301, June.
    12. Erhan Bayraktar & Thomas Cayé & Ibrahim Ekren, 2021. "Asymptotics for small nonlinear price impact: A PDE approach to the multidimensional case," Mathematical Finance, Wiley Blackwell, vol. 31(1), pages 36-108, January.
    13. Alimoradian, Behzad & Barigou, Karim & Eyraud-Loisel, Anne, 2025. "Derivatives under Market Impact: Disentangling Cost and Information," LIDAM Discussion Papers ISBA 2025002, Université catholique de Louvain, Institute of Statistics, Biostatistics and Actuarial Sciences (ISBA).
    14. Joaquin Fernandez-Tapia & Olivier Gu'eant, 2020. "Recipes for hedging exotics with illiquid vanillas," Papers 2005.10064, arXiv.org, revised May 2020.
    15. Thai Nguyen & Mitja Stadje, 2020. "Utility maximization under endogenous pricing," Papers 2005.04312, arXiv.org, revised Jan 2026.
    16. Qianhui Lai & Qiang Yang, 2025. "Deep Learning Strategies for Intraday Optimal Carbon Options Trading with Price Impact Considerations," Mathematics, MDPI, vol. 13(7), pages 1-20, March.
    17. Philippe Bergault & Olivier Gu'eant & Hamza Bodor, 2025. "To Hedge or Not to Hedge: Optimal Strategies for Stochastic Trade Flow Management," Papers 2503.02496, arXiv.org.
    18. Masaaki Fukasawa & Mitja Stadje, 2018. "Perfect hedging under endogenous permanent market impacts," Finance and Stochastics, Springer, vol. 22(2), pages 417-442, April.
    19. David Evangelista & Yuri Saporito & Yuri Thamsten, 2022. "Price formation in financial markets: a game-theoretic perspective," Papers 2202.11416, arXiv.org.
    20. Gao, Rui & Li, Yaqiong & Lin, Lisha, 2019. "Bayesian statistical inference for European options with stock liquidity," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 518(C), pages 312-322.
    21. Dirk Becherer & Todor Bilarev, 2018. "Hedging with physical or cash settlement under transient multiplicative price impact," Papers 1807.05917, arXiv.org, revised Jun 2023.
    22. Behzad Alimoradian & Karim Barigou & Anne Eyraud-Loisel, 2025. "Derivatives under market impact: Disentangling cost and information," Working Papers hal-03668432, HAL.

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