PRICING INDEX OPTIONS BY STATIC HEDGING UNDER FINITE LIQUIDITY

John Armstrong (), Teemu Pennanen () and Udomsak Rakwongwan
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John Armstrong: Department of Mathematics, King’s College London, Strand, London, WC2R 2LS, UK
Teemu Pennanen: Department of Mathematics, King’s College London, Strand, London, WC2R 2LS, UK
Udomsak Rakwongwan: Department of Mathematics, King’s College London, Strand, London, WC2R 2LS, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2018, vol. 21, issue 06, 1-18

Abstract: We develop a model for indifference pricing in derivatives markets, where price quotes have bid–ask spreads and finite quantities. The model quantifies the dependence of the prices and hedging portfolios on an investor’s views, risk preferences and financial position as well as on the price quotes. Computational techniques of convex optimization allow for fast computation of the hedging portfolios and prices as well as sensitivities with respect to various model parameters. We illustrate the techniques by pricing and hedging of exotic derivatives on S&P index using call and put options, forward contracts and cash as the hedging instruments. The optimized static hedges provide good approximations of the options payouts and the spreads between indifference selling and buying prices are quite narrow as compared with the spread between superhedging and subhedging prices.

Keywords: Incomplete markets; indifference pricing; convex optimization (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S0219024918500449

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