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Minimizing Transaction Costs Of Option Hedging Strategies

  • E. R. Grannan
  • G. H. Swindle
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    This paper introduces a method for constructing option hedging strategies in the presence of transaction costs. the approach begins with the prescription of a large, but tractable class of strategies. A variational problem is constructed in which the expected square replication error is minimized subject to a fixed initial portfolio value from among the class of strategies. the solution of this variational problem results in a replicating strategy which simulations show outperforms strategies previously considered. We illustrate this method in a particular class of strategies which contains Leland's discrete time replication scheme. We show that a strategy which uses varying time intervals between hedging can significantly reduce replication error for a given initial wealth. We will also construct and assess strategies obtained by optimizing a mean-variance criterion. This methodology extends to other optimization problems involving initial portfolio value and expected square replication error, as well as to other classes of strategies. Copyright 1996 Blackwell Publishers.

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    Article provided by Wiley Blackwell in its journal Mathematical Finance.

    Volume (Year): 6 (1996)
    Issue (Month): 4 ()
    Pages: 341-364

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    Handle: RePEc:bla:mathfi:v:6:y:1996:i:4:p:341-364
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