Hedging with Temporary Price Impact

Peter Bank, Halil Mete Soner and Moritz Voss
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Peter Bank: Humboldt University of Berlin
Halil Mete Soner: ETH Zurich and Swiss Finance Institute
Moritz Voss: Technische Universität Berlin (TU Berlin)

No 16-72, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We consider the problem of hedging a European contingent claim in a Bachelier model with transient price impact as proposed by Almgren and Chriss. Following the approach of Rogers and Singh [24] and Naujokat and Westray, the hedging problem can be regarded as a cost optimal tracking problem of the frictionless hedging strategy. We solve this problem explicitly for general predictable target hedging strategies. It turns out that, rather than towards the current target position, the optimal policy trades towards a weighted average of expected future target positions. This generalizes an observation of Gârleanu and Pedersen from their homogenous Markovian optimal investment problem to a general hedging problem. Our findings complement a number of previous studies in the literature on optimal strategies in illiquid markets as, where the frictionless hedging strategy is confined to diffusions. The consideration of general predictable reference strategies is made possible by the use of a convex analysis approach instead of the more common dynamic programming methods.

Keywords: Hedging; illiquid markets; portfolio tracking (search for similar items in EconPapers)
JEL-codes: C61 G11 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2016-03
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1672

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