Efficient analytic approximation of the optimal hedging strategy for a European call option with transaction costs

Valeri Zakamouline

Quantitative Finance, 2006, vol. 6, issue 5, 435-445

Abstract: One of the most successful approaches to option hedging with transaction costs is the utility-based approach, pioneered by Hodges and Neuberger [Rev. Futures Markets, 1989, 8, 222-239]. Judging against the best possible trade-off 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 (search for similar items in EconPapers)
Date: 2006
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Citations: View citations in EconPapers (4)

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DOI: 10.1080/14697680600724809

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