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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

Valeriy Zakamulin

University of Agder - School of Business and Law

Date Written: March 10, 2006

Abstract

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

Zakamulin, Valeriy, Efficient Analytic Approximation of the Optimal Hedging Strategy for a European Call Option with Transaction Costs (March 10, 2006). Available at SSRN: https://ssrn.com/abstract=889563 or http://dx.doi.org/10.2139/ssrn.889563

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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