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Hedging American contingent claims with constrained portfolios


  • Ioannis Karatzas

    () (Departments of Mathematics and Statistics, Columbia University, New York, NY 10027, USA)

  • (*), S. G. Kou

    () (Department of Statistics, University of Michigan, Mason Hall, Ann Arbor, MI 48109-1027, USA Manuscript)


The valuation theory for American Contingent Claims, due to Bensoussan (1984) and Karatzas (1988), is extended to deal with constraints on portfolio choice, including incomplete markets and borrowing/short-selling constraints, or with different interest rates for borrowing and lending. In the unconstrained case, the classical theory provides a single arbitrage-free price $u_0$; this is expressed as the supremum, over all stopping times, of the claim's expected discounted value under the equivalent martingale measure. In the presence of constraints, $\{u_0\}$ is replaced by an entire interval $[h_{\rm low}, h_{\rm up}]$ of arbitrage-free prices, with endpoints characterized as $h_{\rm low} = \inf_{\nu\in{\cal D}} u_\nu, h_{\rm up} = \sup_{\nu\in{\cal D}} u_\nu$. Here $u_\nu$ is the analogue of $u_0$, the arbitrage-free price with unconstrained portfolios, in an auxiliary market model ${\cal M}_\nu$; and the family $\{{\cal M}_\nu\}_{\nu\in{\cal D}}$ is suitably chosen, to contain the original model and to reflect the constraints on portfolios. For several such constraints, explicit computations of the endpoints are carried out in the case of the American call-option. The analysis involves novel results in martingale theory (including simultaneous Doob-Meyer decompositions), optimal stopping and stochastic control problems, stochastic games, and uses tools from convex analysis.

Suggested Citation

  • Ioannis Karatzas & (*), S. G. Kou, 1998. "Hedging American contingent claims with constrained portfolios," Finance and Stochastics, Springer, vol. 2(3), pages 215-258.
  • Handle: RePEc:spr:finsto:v:2:y:1998:i:3:p:215-258
    Note: received: July 1996; final version received: November 1996

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    References listed on IDEAS

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    1. Jensen, Mads Vestergaard & Pedersen, Lasse Heje, 2016. "Early option exercise: Never say never," Journal of Financial Economics, Elsevier, vol. 121(2), pages 278-299.
    2. Riedel, Frank & Herzberg, Frederik, 2013. "Existence of financial equilibria in continuous time with potentially complete markets," Journal of Mathematical Economics, Elsevier, vol. 49(5), pages 398-404.
    3. Karatzas, Ioannis & Ocone, Daniel, 2002. "A leavable bounded-velocity stochastic control problem," Stochastic Processes and their Applications, Elsevier, vol. 99(1), pages 31-51, May.
    4. Erhan Bayraktar & Zhou Zhou, 2012. "On controller-stopper problems with jumps and their applications to indifference pricing of American options," Papers 1212.4894,, revised Nov 2013.
    5. Haluk Yener, 2015. "Maximizing survival, growth and goal reaching under borrowing constraints," Quantitative Finance, Taylor & Francis Journals, vol. 15(12), pages 2053-2065, December.
    6. Erhan Bayraktar & Yu-Jui Huang, 2010. "On the Multi-Dimensional Controller and Stopper Games," Papers 1009.0932,, revised Jan 2013.
    7. Tianyang Nie & Marek Rutkowski, 2016. "A BSDE approach to fair bilateral pricing under endogenous collateralization," Finance and Stochastics, Springer, vol. 20(4), pages 855-900, October.
    8. Roxana Dumitrescu & Marie-Claire Quenez & Agn`es Sulem, 2016. "BSDEs with default jump," Papers 1612.05681,, revised Sep 2017.
    9. Erhan Bayraktar & Song Yao, 2013. "On the Robust Optimal Stopping Problem," Papers 1301.0091,, revised Apr 2016.
    10. Beatrice Acciaio & Gregor Svindland, 2014. "On The Lower Arbitrage Bound Of American Contingent Claims," Mathematical Finance, Wiley Blackwell, vol. 24(1), pages 147-155, January.
    11. Alet Roux, 2007. "The fundamental theorem of asset pricing under proportional transaction costs," Papers 0710.2758,
    12. Henderson, Vicky & Hobson, David, 2007. "Horizon-unbiased utility functions," Stochastic Processes and their Applications, Elsevier, vol. 117(11), pages 1621-1641, November.
    13. M. Pınar & A. Camcı, 2012. "An Integer Programming Model for Pricing American Contingent Claims under Transaction Costs," Computational Economics, Springer;Society for Computational Economics, vol. 39(1), pages 1-12, January.
    14. Zhou, Qing & Wu, Weixing & Wang, Zengwu, 2008. "Cooperative hedging with a higher interest rate for borrowing," Insurance: Mathematics and Economics, Elsevier, vol. 42(2), pages 609-616, April.
    15. Xiongfei Jian & Xun Li & Fahuai Yi, 2014. "Optimal Investment with Stopping in Finite Horizon," Papers 1406.6940,
    16. Denis Belomestny & Volker Kraetschmer, 2017. "Minimax theorems for American options in incomplete markets without time-consistency," Papers 1708.08904,
    17. Fu, Chenpeng & Lari-Lavassani, Ali & Li, Xun, 2010. "Dynamic mean-variance portfolio selection with borrowing constraint," European Journal of Operational Research, Elsevier, vol. 200(1), pages 312-319, January.
    18. Chudjakow, Tatjana & Vorbrink, Jörg, 2011. "Exercise strategies for American exotic options under ambiguity," Center for Mathematical Economics Working Papers 421, Center for Mathematical Economics, Bielefeld University.
    19. Kuhn, Christoph, 2002. "Pricing contingent claims in incomplete markets when the holder can choose among different payoffs," Insurance: Mathematics and Economics, Elsevier, vol. 31(2), pages 215-233, October.
    20. Tomasz R. Bielecki & Igor Cialenco & Marek Rutkowski, 2017. "Arbitrage-Free Pricing Of Derivatives In Nonlinear Market Models," Papers 1701.08399,
    21. Erhan Bayraktar & Arash Fahim, 2011. "A Stochastic Approximation for Fully Nonlinear Free Boundary Parabolic Problems," Papers 1109.5752,, revised Nov 2013.
    22. Aliprantis, Charalambos D. & Polyrakis, Yiannis A. & Tourky, Rabee, 2002. "The cheapest hedge," Journal of Mathematical Economics, Elsevier, vol. 37(4), pages 269-295, July.
    23. Acciaio, Beatrice & Svindland, Gregor, 2014. "On the lower arbitrage bound of American contingent claims," LSE Research Online Documents on Economics 50117, London School of Economics and Political Science, LSE Library.
    24. Duffie, Darrell, 2003. "Intertemporal asset pricing theory," Handbook of the Economics of Finance,in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 11, pages 639-742 Elsevier.
    25. Matos, Joao Amaro de & Lacerda, Ana, 2004. "Dry Markets and Superreplication Bounds of American Derivatives," FEUNL Working Paper Series wp461, Universidade Nova de Lisboa, Faculdade de Economia.

    More about this item


    Contingent claims; hedging; pricing; arbitrage; constrained markets; incomplete markets; different interest rates; Black-Scholes formula; optimal stopping; free boundary; stochastic control; stochastic games; equivalent martingale measures; simultaneous Doob-Meyer decompositions.;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General


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