Efficient Analytic Approximation of the Optimal Hedging Strategy for a European Call Option with Transaction Costs
31 Pages Posted: 4 Feb 2010 Last revised: 9 Feb 2010
Date Written: March 10, 2006
One of the most successful approaches to option hedging with transaction costs is the utility based approach, pioneered by Hodges and Neuberger (1989). Judging against the best possible tradeoff between the risk and the costs of a hedging strategy, this approach seems to achieve excellent empirical performance. However, this approach has one major drawback that prevents the broad application of this approach in practice: the lack of a closed-form solution. We overcome this drawback by presenting a simple yet efficient analytic approximation of the solution. We provide an empirical testing of our approximation strategy against the asymptotic and some other well-known strategies and find that our strategy outperforms all the others.
Keywords: option hedging, transaction costs, approximation methods, simulations
JEL Classification: G11, G13
Suggested Citation: Suggested Citation