American Option Pricing and Exercising with Transaction Costs

Norwegian School of Economics and Business Administration Discussion Paper No. 15/2003

40 Pages Posted: 15 Feb 2010  

Valeriy Zakamulin

University of Agder - School of Business and Law

Date Written: November 1, 2003

Abstract

In this paper we examine the problem of finding the reservation option prices and corresponding exercise policies of American options in a market with proportional transaction costs using the utility based approach proposed by Davis and Zariphopoulou (1995). We present a model where the option holder has a constant absolute risk aversion. We discuss the numerical algorithm and propose a new characterization of the option holder's value function. We suggest original discretization schemes for computing reservation prices and exercise policies of American options. The discretization schemes are implemented for the cases of American put and call options. We present the study of the optimal transaction policy of the option holder. We examine the effects on the reservation option prices and the corresponding exercise policies of varying the levels of absolute risk aversion and transaction costs.

Keywords: option pricing, transaction costs, stochastic control, optimal stopping, Markov chain approximation

JEL Classification: C61, G11, G13

Suggested Citation

Zakamulin, Valeriy, American Option Pricing and Exercising with Transaction Costs (November 1, 2003). Norwegian School of Economics and Business Administration Discussion Paper No. 15/2003. Available at SSRN: https://ssrn.com/abstract=473681 or http://dx.doi.org/10.2139/ssrn.473681

Valeriy Zakamulin (Contact Author)

University of Agder - School of Business and Law ( email )

Service Box 422
Kristiansand, N-4604
Norway
+47 38141039 (Phone)

HOME PAGE: http://vzakamulin.weebly.com/

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