Option valuation with liquidity risk and jumps

Hai Zhang and Hyejin Ku

Applied Economics Letters, 2018, vol. 25, issue 6, 381-387

Abstract: This article provides a simple model for pricing and hedging options in the presence of jumps and liquidity costs. In the article, liquidity risk is modelled via a stochastic supply curve function and a jump-diffusion process is approximated by a Markov chain. Local risk minimization incorporating liquidity risk is proposed to price and hedge European options in this discrete-time model. Moreover, an example is provided to implement the modified risk minimization method and to demonstrate the performance of hedging strategies.

Date: 2018
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DOI: 10.1080/13504851.2017.1324606

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