Discrete time hedging with liquidity risk

Hyejin Ku, Kiseop Lee and Huaiping Zhu

Finance Research Letters, 2012, vol. 9, issue 3, 135-143

Abstract: We study a discrete time hedging and pricing problem in a market with liquidity costs. Using Leland’s discrete time replication scheme [Leland, H.E., 1985. Journal of Finance, 1283–1301], we consider a discrete time version of the Black–Scholes model and a delta hedging strategy. We derive a partial differential equation for the option price in the presence of liquidity costs and develop a modified option hedging strategy which depends on the size of the parameter for liquidity risk. We also discuss an analytic method of solving the pricing equation using a series solution.

Keywords: Discrete time; Liquidity cost; Delta hedging (search for similar items in EconPapers)
JEL-codes: C30 C65 G11 G13 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:9:y:2012:i:3:p:135-143

DOI: 10.1016/j.frl.2012.02.002

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