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American Option Pricing with Transaction Costs

Listed author(s):
  • Valeri Zakamouline

    (Norwegian School of Economics & Business Administration)

Registered author(s):

    In this paper we examine the problem of finding investors' reservation option prices and corresponding early exercise policies of American- style options in the market with proportional transaction costs using the utility based approach proposed by Davis and Zariphopoulou (1995). We present a model, where investors have a CARA utility, and derive some properties of reservation option prices. We discuss the numerical algorithm and propose a new formulation of the problem in terms of quasi-variational HJB inequalities. Based on our formulation, we suggest original discretization schemes for computing reservation prices of American-style option. The discretization schemes are then implemented for computing prices of American put and call options. We examine the effects on the reservation option prices and the corresponding early exercise policies of varying the investor's ARA and the level of transaction costs. We find that in the market with transaction costs the holder of an American-style option exercises this option earlier as compared to the case with no transaction costs. This phenomenon concerns both put and call options written on a non-dividend paying stock. The higher level the transaction costs is, or the higher risk avers the option holder is, the earlier an American option is exercised.

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    Paper provided by EconWPA in its series Finance with number 0311012.

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    Length: 51 pages
    Date of creation: 28 Nov 2003
    Handle: RePEc:wpa:wuwpfi:0311012
    Note: Type of Document - pdf; prepared on WinXP; pages: 51; figures: 11
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    1. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    2. 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.
    3. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
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