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Optimal Hedging of Option Portfolios with Transaction Costs

28 Pages Posted: 20 Oct 2006  

Valeriy Zakamulin

University of Agder - School of Business and Law

Date Written: August 15, 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). However, this approach has one major drawback that prevents the broad application of this approach in practice: the lack of a closed-form solution. The direct numerical computations of the utility based hedging strategy are cumbersome in a practical implementation. Despite some recent advances in finding an explicit description of the utility based hedging strategy by using either asymptotic, approximation, or other methods, so far they were concerned primarily with hedging a single plain-vanilla option. However, in practice one often faces the problem of hedging a portfolio of options on the same underlying asset. Since the knowledge of the optimal hedging strategy for a portfolio of options is of great practical significance, in this paper we suggest a simplified parameterized description of the utility based hedging strategy for a portfolio of options and a simple method for finding the optimal parameters. We provide an empirical testing of our optimized hedging strategies against some alternative strategies and show that our strategies outperform all the others.

Keywords: option hedging, transaction costs, simulations

JEL Classification: G11, G13

Suggested Citation

Zakamulin, Valeriy, Optimal Hedging of Option Portfolios with Transaction Costs (August 15, 2006). Available at SSRN: https://ssrn.com/abstract=938934 or http://dx.doi.org/10.2139/ssrn.938934

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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