Density estimation through quasi-analytic Monte-Carlo simulation: Options arbitrage with transactions costs
Discretely rebalanced options arbitrage strategies in the presence of transaction costs have path dependent returns that are difficult to model analytically. I instead use a quasi-analytic procedure that combines the computational efficiency of analytical solutions with the flexibility of simulations. The central feature is the estimation of the distribution of returns of the arbitrage strategy by mapping simulated returns percentiles and the input parameter set. Using the estimated density, I evaluate the tradeoff between transaction costs and risk exposure under generalized transaction costs structures that includes bid-ask spread and brokerage commission. I show that the optimal strategy depends on transaction costs, volatility, and option moneyness. Strategies such as rebalancing when the hedge ratio changes by 0.25, balances transaction costs and risk exposure, and can be optimal. Copyright Springer Science+Business Media, LLC 2007
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Volume (Year): 28 (2007)
Issue (Month): 1 (January)
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References listed on IDEAS
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- Leland, Hayne E, 1985.
" Option Pricing and Replication with Transactions Costs,"
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- Hayne E. Leland., 1984. "Option Pricing and Replication with Transactions Costs," Research Program in Finance Working Papers 144, University of California at Berkeley.
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- Russell P. Robins & Barry Schachter, 1994. "An Analysis of the Risk in Discretely Rebalanced Option Hedges and Delta-Based Techniques," Management Science, INFORMS, vol. 40(6), pages 798-808, June.
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- Brennan, M J, 1979. "The Pricing of Contingent Claims in Discrete Time Models," Journal of Finance, American Finance Association, vol. 34(1), pages 53-68, March.
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