European Option Pricing and Hedging with both Fixed and Proportional Transaction Costs
In this paper we extend the utility based option pricing and hedging approach, pioneered by Hodges and Neuberger (1989) and further developed by Davis, Panas and Zariphopoulou (1993), for the market where each transaction has a fixed cost component. We present a model, where investors have a CARA utility, and derive some properties of reservation option prices. We suggest and implement discretization schemes for computing the reservation option prices. The numerical results of option pricing and hedging are presented for the case of European call options and the investors with different levels of ARA. We also try to reconcile our findings with such empirical pricing bias as the volatility smile.
|Date of creation:||21 Nov 2003|
|Date of revision:|
|Note:||Type of Document - pdf; prepared on WinXP; pages: 43; figures: 6|
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- Dermody, Jaime Cuevas & Prisman, Eliezer Z., 1993. "No Arbitrage and Valuation in Markets with Realistic Transaction Costs," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(01), pages 65-80, March.
- George M. Constantinides & Thaleia Zariphopoulou, .
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CRSP working papers
347, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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- Benjamin Mohamed, 1994. "Simulations of transaction costs and optimal rehedging," Applied Mathematical Finance, Taylor & Francis Journals, vol. 1(1), pages 49-62.
- A. E. Whalley & P. Wilmott, 1997. "An Asymptotic Analysis of an Optimal Hedging Model for Option Pricing with Transaction Costs," Mathematical Finance, Wiley Blackwell, vol. 7(3), pages 307-324.
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