IDEAS home Printed from https://ideas.repec.org/a/wsi/ijtafx/v21y2018i06ns0219024918500449.html
   My bibliography  Save this article

Pricing Index Options By Static Hedging Under Finite Liquidity

Author

Listed:
  • JOHN ARMSTRONG

    (Department of Mathematics, King’s College London, Strand, London, WC2R 2LS, UK)

  • TEEMU PENNANEN

    (Department of Mathematics, King’s College London, Strand, London, WC2R 2LS, UK)

  • UDOMSAK RAKWONGWAN

    (Department of Mathematics, King’s College London, Strand, London, WC2R 2LS, UK)

Abstract

We develop a model for indifference pricing in derivatives markets, where price quotes have bid–ask spreads and finite quantities. The model quantifies the dependence of the prices and hedging portfolios on an investor’s views, risk preferences and financial position as well as on the price quotes. Computational techniques of convex optimization allow for fast computation of the hedging portfolios and prices as well as sensitivities with respect to various model parameters. We illustrate the techniques by pricing and hedging of exotic derivatives on S&P index using call and put options, forward contracts and cash as the hedging instruments. The optimized static hedges provide good approximations of the options payouts and the spreads between indifference selling and buying prices are quite narrow as compared with the spread between superhedging and subhedging prices.

Suggested Citation

  • John Armstrong & Teemu Pennanen & Udomsak Rakwongwan, 2018. "Pricing Index Options By Static Hedging Under Finite Liquidity," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(06), pages 1-18, September.
    • Handle: RePEc:wsi:ijtafx:v:21:y:2018:i:06:n:s0219024918500449
    DOI: 10.1142/S0219024918500449
    as

    Download full text from publisher

    File URL: http://www.worldscientific.com/doi/abs/10.1142/S0219024918500449
    Download Restriction: Access to full text is restricted to subscribers
    File URL: https://libkey.io/10.1142/S0219024918500449?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Teemu Pennanen, 2014. "Optimal investment and contingent claim valuation in illiquid markets," Finance and Stochastics, Springer, vol. 18(4), pages 733-754, October.
    2. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-651, October.
    3. Alan J. King & Matti Koivu & Teemu Pennanen, 2005. "Calibrated Option Bounds," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(02), pages 141-159.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Teemu Pennanen & Udomsak Rakwongwan, 2020. "Optimal semi-static hedging in illiquid markets," Papers 2008.01463, arXiv.org.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Martin Glanzer & Georg Ch. Pflug & Alois Pichler, 2017. "Incorporating statistical model error into the calculation of acceptability prices of contingent claims," Papers 1703.05709, arXiv.org, revised Jan 2019.
    2. Peter Carr & Liuren Wu, 2014. "Static Hedging of Standard Options," The Journal of Financial Econometrics, Society for Financial Econometrics, vol. 12(1), pages 3-46.
    3. Marins, Jaqueline Terra Moura & Vicente, José Valentim Machado, 2017. "Do the central bank actions reduce interest rate volatility?," Economic Modelling, Elsevier, vol. 65(C), pages 129-137.
    4. René Garcia & Richard Luger & Eric Renault, 2000. "Asymmetric Smiles, Leverage Effects and Structural Parameters," Working Papers 2000-57, Center for Research in Economics and Statistics.
    5. Barone-Adesi, Giovanni & Fusari, Nicola & Mira, Antonietta & Sala, Carlo, 2020. "Option market trading activity and the estimation of the pricing kernel: A Bayesian approach," Journal of Econometrics, Elsevier, vol. 216(2), pages 430-449.
    6. Hongzhong Zhang, 2018. "Stochastic Drawdowns," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 10078, December.
    7. Petros Dellaportas & Aleksandar Mijatovi'c, 2014. "Arbitrage-free prediction of the implied volatility smile," Papers 1407.5528, arXiv.org.
    8. Christoffersen, Peter & Heston, Steven & Jacobs, Kris, 2010. "Option Anomalies and the Pricing Kernel," Working Papers 11-17, University of Pennsylvania, Wharton School, Weiss Center.
    9. Geert Bekaert & Eric Engstrom, 2017. "Asset Return Dynamics under Habits and Bad Environment-Good Environment Fundamentals," Journal of Political Economy, University of Chicago Press, vol. 125(3), pages 713-760.
    10. Kitsul, Yuriy & Wright, Jonathan H., 2013. "The economics of options-implied inflation probability density functions," Journal of Financial Economics, Elsevier, vol. 110(3), pages 696-711.
    11. Jobst, Andreas A., 2014. "Measuring systemic risk-adjusted liquidity (SRL)—A model approach," Journal of Banking & Finance, Elsevier, vol. 45(C), pages 270-287.
    12. Lynn Boen & Florence Guillaume, 2020. "Towards a $$\Delta $$Δ-Gamma Sato multivariate model," Review of Derivatives Research, Springer, vol. 23(1), pages 1-39, April.
    13. Bertrand, Philippe & Prigent, Jean-luc, 2016. "Equilibrium of financial derivative markets under portfolio insurance constraints," Economic Modelling, Elsevier, vol. 52(PA), pages 278-291.
    14. Huang, Lin & Wu, Jia & Zhang, Rui, 2014. "Exchange risk and asset returns: A theoretical and empirical study of an open economy asset pricing model," Emerging Markets Review, Elsevier, vol. 21(C), pages 96-116.
    15. Alexandre M. Baptista, 2005. "Options And Efficiency In Multidate Security Markets," Mathematical Finance, Wiley Blackwell, vol. 15(4), pages 569-587, October.
    16. Ricardo Crisóstomo, 2021. "Estimating real‐world probabilities: A forward‐looking behavioral framework," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(11), pages 1797-1823, November.
    17. Monteiro, Ana Margarida & Tutuncu, Reha H. & Vicente, Luis N., 2008. "Recovering risk-neutral probability density functions from options prices using cubic splines and ensuring nonnegativity," European Journal of Operational Research, Elsevier, vol. 187(2), pages 525-542, June.
    18. Zhang, Han & Guo, Bin & Liu, Lanbiao, 2022. "The time-varying bond risk premia in China," Journal of Empirical Finance, Elsevier, vol. 65(C), pages 51-76.
    19. Jaroslav Borovička & Lars Peter Hansen & José A. Scheinkman, 2016. "Misspecified Recovery," Journal of Finance, American Finance Association, vol. 71(6), pages 2493-2544, December.
    20. Carole Bernard & Franck Moraux & Ludger R�schendorf & Steven Vanduffel, 2015. "Optimal payoffs under state-dependent preferences," Quantitative Finance, Taylor & Francis Journals, vol. 15(7), pages 1157-1173, July.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wsi:ijtafx:v:21:y:2018:i:06:n:s0219024918500449. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Tai Tone Lim (email available below). General contact details of provider: http://www.worldscinet.com/ijtaf/ijtaf.shtml .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.