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Backward Hedging for American Options with Transaction Costs

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  • Ludovic Gouden`ege
  • Andrea Molent
  • Antonino Zanette

Abstract

In this article, we introduce an algorithm called Backward Hedging, designed for hedging European and American options while considering transaction costs. The optimal strategy is determined by minimizing an appropriate loss function, which is based on either a risk measure or the mean squared error of the hedging strategy at maturity. The proposed algorithm moves backward in time, determining, for each time-step and different market states, the optimal hedging strategy that minimizes the loss function at the time the option is exercised, by assuming that the strategy used in the future for hedging the liability is the one determined at the previous steps of the algorithm. The approach avoids machine learning and instead relies on classic optimization techniques, Monte Carlo simulations, and interpolations on a grid. Comparisons with the Deep Hedging algorithm in various numerical experiments showcase the efficiency and accuracy of the proposed method.

Suggested Citation

  • Ludovic Gouden`ege & Andrea Molent & Antonino Zanette, 2023. "Backward Hedging for American Options with Transaction Costs," Papers 2305.06805, arXiv.org, revised Jun 2023.
    • Handle: RePEc:arx:papers:2305.06805
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    References listed on IDEAS

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