Option Pricing and Hedging with Small Transaction Costs

23 Pages Posted: 18 Sep 2012 Last revised: 20 Dec 2012

See all articles by Jan Kallsen

Jan Kallsen

Munich University of Technology

Johannes Muhle-Karbe

Carnegie Mellon University - Department of Mathematical Sciences

Multiple version iconThere are 2 versions of this paper

Date Written: September 18, 2012

Abstract

An investor with constant absolute risk aversion trades a risky asset with general ItĂ´dynamics, 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 indi erence prices and hedging strategies in the presence of small transaction costs.

Keywords: transaction costs, indifference pricing and hedging, exponential utility, asymptotics

JEL Classification: G13, G11

Suggested Citation

Kallsen, Jan and Muhle-Karbe, Johannes, Option Pricing and Hedging with Small Transaction Costs (September 18, 2012). Swiss Finance Institute Research Paper No. 12-30. Available at SSRN: https://ssrn.com/abstract=2148502 or http://dx.doi.org/10.2139/ssrn.2148502

Jan Kallsen

Munich University of Technology ( email )

Arcisstrasse 21
Munich, 80333
Germany

Johannes Muhle-Karbe (Contact Author)

Carnegie Mellon University - Department of Mathematical Sciences ( email )

Pittsburgh, PA 15213-3890
United States

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