European Option Pricing and Hedging with both Fixed and Proportional Transaction Costs

Valeri Zakamouline
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Valeri Zakamouline: Norwegian School of Economics & Business Administration

Finance from EconWPA

Abstract: In this paper we extend the utility based option pricing and hedging approach, pioneered by Hodges and Neuberger (1989) and further developed by Davis, Panas and Zariphopoulou (1993), for the market where each transaction has a fixed cost component. We present a model, where investors have a CARA utility, and derive some properties of reservation option prices. We suggest and implement discretization schemes for computing the reservation option prices. The numerical results of option pricing and hedging are presented for the case of European call options and the investors with different levels of ARA. We also try to reconcile our findings with such empirical pricing bias as the volatility smile.

Keywords: option pricing; transaction costs; stochastic control; Markov chain approximation (search for similar items in EconPapers)
JEL-codes: C61 G11 G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn, nep-eec, nep-fin and nep-rmg
Date: 2003-11-21
Note: Type of Document - pdf; prepared on WinXP; pages: 43; figures: 6
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:0311009

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