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Feedback effects of dynamic hedging strategies in the presence of transaction costs

Listed author(s):
  • E. Agliardi
  • R. Andergassen

We study the destabilising effect of dynamic hedging strategies on the price of the underlying in the presence of sunk costs of transaction. Once sunk costs of transaction are taken into account, continuous portfolio rehedging is no longer an optimal strategy. Using a non-optimising (local in time) strategy for portfolio rebalancing, explicit dynamics for the price of the underlying are derived, focusing in particular on the excess volatility and feedback effects of these portfolio insurance strategies. Further, we show how these latter depend on the heterogeneity of the insured payoffs. Finally, conditions are derived under which it may still be reasonable, from a practical viewpoint, to implement Black - Scholes strategies.

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File URL: https://amsacta.unibo.it/4851/1/445.pdf
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Paper provided by Dipartimento Scienze Economiche, Universita' di Bologna in its series Working Papers with number 445.

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Date of creation: 2002
Handle: RePEc:bol:bodewp:445
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  1. Ricardo J. Caballero & Eduardo M. R. A. Engel, 1993. "Microeconomic Adjustment Hazards and Aggregate Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 108(2), pages 359-383.
  2. Grossman, Sanford J, 1988. "An Analysis of the Implications for Stock and Futures Price Volatility of Program Trading and Dynamic Hedging Strategies," The Journal of Business, University of Chicago Press, vol. 61(3), pages 275-298, July.
  3. RĂ¼diger Frey & Alexander Stremme, 1997. "Market Volatility and Feedback Effects from Dynamic Hedging," Mathematical Finance, Wiley Blackwell, vol. 7(4), pages 351-374.
  4. Platen, Eckhard & Martin Schweizer, 1994. "On Smile and Skewness," Discussion Paper Serie B 302, University of Bonn, Germany.
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