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Hedging with Temporary Price Impact

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  • Peter Bank
  • Mete Soner
  • Moritz Vo{ss}

Abstract

We consider the problem of hedging a European contingent claim in a Bachelier model with transient price impact as proposed by Almgren and Chriss. Following the approach of Rogers and Singh and Naujokat and Westray, the hedging problem can be regarded as a cost optimal tracking problem of the frictionless hedging strategy. We solve this problem explicitly for general predictable target hedging strategies. It turns out that, rather than towards the current target position, the optimal policy trades towards a weighted average of expected future target positions. This generalizes an observation of Garleanu and Pedersen from their homogenous Markovian optimal investment problem to a general hedging problem. Our findings complement a number of previous studies in the literature on optimal strategies in illiquid markets where the frictionless strategy is confined to diffusions. The consideration of general predictable reference strategies is made possible by the use of a convex analysis approach instead of the more common dynamic programming methods.

Suggested Citation

  • Peter Bank & Mete Soner & Moritz Vo{ss}, 2015. "Hedging with Temporary Price Impact," Papers 1510.03223, arXiv.org, revised Jul 2016.
  • Handle: RePEc:arx:papers:1510.03223
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    File URL: http://arxiv.org/pdf/1510.03223
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    References listed on IDEAS

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    5. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
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    7. Jan Kallsen & Johannes Muhle-Karbe, 2014. "High-Resilience Limits of Block-Shaped Order Books," Papers 1409.7269, arXiv.org.
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    9. Olivier Guéant & Jiang Pu, 2015. "Option pricing and hedging with execution costs and market impact," Post-Print hal-01393124, HAL.
    10. Olivier Gu'eant & Jiang Pu, 2013. "Option pricing and hedging with execution costs and market impact," Papers 1311.4342, arXiv.org, revised Apr 2015.
    11. Jiatu Cai & Mathieu Rosenbaum & Peter Tankov, 2015. "Asymptotic Lower Bounds for Optimal Tracking: a Linear Programming Approach," Papers 1510.04295, arXiv.org.
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    Cited by:

    1. Andrew Papanicolaou & Shiva Chandra, 2019. "Singular Perturbation Expansion for Utility Maximization with Order-$\epsilon$ Quadratic Transaction Costs," Papers 1910.06463, arXiv.org, revised Nov 2019.
    2. Dirk Becherer & Todor Bilarev, 2018. "Hedging with transient price impact for non-covered and covered options," Papers 1807.05917, arXiv.org.
    3. Jiatu Cai & Mathieu Rosenbaum & Peter Tankov, 2015. "Asymptotic Lower Bounds for Optimal Tracking: a Linear Programming Approach," Papers 1510.04295, arXiv.org.

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