Efficient Option Pricing with Transaction Costs
A fast numerical algorithm is developed to price European options with proportional transaction costs using the utility maximization framework of Davis (1997). This approach allows option prices to be computed by solving the investor's basic portfolio selection problem, without the insertion of the option payoff into the terminal value function. The properties of the value function can then be used to drastically reduce the number of operations needed to locate the boundaries of the no transaction region, which leads to very efficient option valuation. The optimization problem is solved numerically for the case of exponential utility, and comparisons with approximately replicating strategies reveal tight bounds for option prices even as transaction costs become large. The computational technique involves a discrete time Markov chain approximation to a continuous time singular stochastic optimal control problem. A general de nition of an option hedging strategy in this framework is developed. This involves calculating the perturbation to the optimal portfolio strategy when an option trade is executed.
|Date of creation:||Jul 2002|
|Date of revision:|
|Contact details of provider:|| Postal: |
When requesting a correction, please mention this item's handle: RePEc:bru:bruedp:02-22. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (John.Hunter)
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 references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link 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 profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.