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Pricing index options by static hedging under finite liquidity

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  • John Armstrong
  • Teemu Pennanen
  • Udomsak Rakwongwan

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 beliefs, risk preferences and financial position as well as on the price quotes. Computational techniques of convex optimisation 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 super- and subhedging prices.

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  • John Armstrong & Teemu Pennanen & Udomsak Rakwongwan, 2018. "Pricing index options by static hedging under finite liquidity," Papers 1803.02486, arXiv.org.
    • Handle: RePEc:arx:papers:1803.02486
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    References listed on IDEAS

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    1. 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.
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    Cited by:

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

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