Transaction Costs and the Implied Volatility Smile
Posted: 3 Apr 1997
Date Written: December 1996
Proportional transaction costs are considered as a possible explanation of the volatility smile of index options. A tight upper bound on the call option price is derived in the presence of proportional transaction costs by extending stochastic dominance arguments. A tight and novel lower bound on the call option price is derived by imposing a plausible upper bound on the investor's relative risk aversion coefficient. The bounds are sufficiently tight to reject the hypothesis that transaction costs can account for the volatility smile in an otherwise Black-Scholes market environment.
JEL Classification: G13
Suggested Citation: Suggested Citation