European Options under Proportional Transaction Costs: An Algorithmic Approach to Pricing and Hedging

Abstract:     
The paper is devoted to optimal superreplication of European options in the discrete setting under proportional transaction costs on the underlying asset. In particular, general pricing and hedging algorithms are developed. This extends previous work by many authors, which has been focused on the binomial tree model and options with specific payoffs such as calls or puts, often under certain bounds on the magnitude of transaction costs. All such restrictions are hereby removed. The results apply to options with arbitrary payoffs in the general discrete market model with arbitrary proportional transaction costs. Numerical examples are presented to illustrate the results and their relationships to the earlier work on pricing options under transaction costs.

Number of Pages in PDF File: 20

Keywords: transaction costs, options, pricing, hedging, superreplication

JEL Classification: G13, C61, C63

working papers series