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Option Pricing and Hedging with Small Transaction Costs

Author

Listed:
  • Jan Kallsen

    (Munich University of Technology)

  • Johannes Muhle-Karbe

    (University of Michigan at Ann Arbor)

Abstract

An investor with constant absolute risk aversion trades a risky asset with general Itôdynamics, in the presence of small proportional transaction costs. In this setting, we formally derive a leading-order optimal trading policy and the associated welfare, expressed in terms of the local dynamics of the frictionless optimizer. By applying these results in the presence of a random endowment, we obtain asymptotic formulas for utility indifference prices and hedging strategies in the presence of small transaction costs.

Suggested Citation

  • Jan Kallsen & Johannes Muhle-Karbe, 2012. "Option Pricing and Hedging with Small Transaction Costs," Swiss Finance Institute Research Paper Series 12-30, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp1230
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    File URL: http://ssrn.com/abstract=2148502
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    More about this item

    Keywords

    transaction costs; indifference pricing and hedging; exponential utility; asymptotics;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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