# Mean square error for the Leland–Lott hedging strategy: convex pay-offs

## Author Info

• Emmanuel Denis

()

• Yuri Kabanov

()

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## Abstract

Leland’s approach to the hedging of derivatives under proportional transaction costs is based on an approximate replication of the European-type contingent claim V T using the classical Black–Scholes formula with a suitably enlarged volatility. The formal mathematical framework is a scheme of series, i.e., a sequence of models with transaction cost coefficients k n =k 0 n −α , where α∈[0,1/2] and n is the number of portfolio revision dates. The enlarged volatility $\widehat{\sigma}_{n}$ in general depends on n except for the case which was investigated in detail by Lott, to whom belongs the first rigorous result on convergence of the approximating portfolio value $V^{n}_{T}$ to the pay-off V T . In this paper, we consider only the Lott case α=1/2. We prove first, for an arbitrary pay-off V T =G(S T ) where G is a convex piecewise smooth function, that the mean square approximation error converges to zero with rate n −1/2 in L 2 and find the first order term of the asymptotics. We are working in a setting with non-uniform revision intervals and establish the asymptotic expansion when the revision dates are $t_{i}^{n}=g(i/n)$, where the strictly increasing scale function g:[0,1]→[0,1] and its inverse f are continuous with their first and second derivatives on the whole interval, or g(t)=1−(1−t) β , β≥1. We show that the sequence $n^{1/2}(V_{T}^{n}-V_{T})$ converges in law to a random variable which is the terminal value of a component of a two-dimensional Markov diffusion process and calculate the limit. Our central result is a functional limit theorem for the discrepancy process.

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## Bibliographic Info

Article provided by Springer in its journal Finance and Stochastics.

Volume (Year): 14 (2010)
Issue (Month): 4 (December)
Pages: 625-667

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 Handle: RePEc:spr:finsto:v:14:y:2010:i:4:p:625-667 Contact details of provider: Web page: http://www.springerlink.com/content/101164/ Order Information: Web: http://link.springer.de/orders.htm

## References

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1. Yuri M. Kabanov & (*), Mher M. Safarian, 1997. "On Leland's strategy of option pricing with transactions costs," Finance and Stochastics, Springer, vol. 1(3), pages 239-250.
2. Emmanuel Temam & Emmanuel Gobet, 2001. "Discrete time hedging errors for options with irregular payoffs," Finance and Stochastics, Springer, vol. 5(3), pages 357-367.
3. Hayne E. Leland., 1984. "Option Pricing and Replication with Transactions Costs," Research Program in Finance Working Papers 144, University of California at Berkeley.
4. Zhao, Yonggan & Ziemba, William T., 2007. "Hedging errors with Leland's option model in the presence of transaction costs," Finance Research Letters, Elsevier, vol. 4(1), pages 49-58, March.
5. Leland, Hayne E., 2007. "Comments on "Hedging errors with Leland's option model in the presence of transactions costs"," Finance Research Letters, Elsevier, vol. 4(3), pages 200-202, September.
6. E. R. Grannan & G. H. Swindle, 1996. "Minimizing Transaction Costs Of Option Hedging Strategies," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 341-364.
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