The Effect of Correlation and Transaction Costs on the Pricing of Basket Options
C. Atkinson and
P. Ingpochai
Applied Mathematical Finance, 2012, vol. 19, issue 2, 131-179
Abstract:
In this article, we examine the problem of evaluating the option price of a European call option written on N underlying assets when there are proportional transaction costs in the market. Since the portfolio under consideration consists of multiple risky assets, which makes numerical methods formidable, we use perturbation analyses. The article extends the model for option pricing on uncorrelated assets, which was proposed by Atkinson and Alexandropoulos (2006; Pricing a European basket option in the presence of proportional transaction cost, Applied Mathematical Finance , 13(3), pp. 191--214). We determine optimal hedging strategies as well as option prices on both correlated and uncorrelated assets. The option valuation problem is obtained by comparing the maximized utility of wealth with and without option liability. The two stochastic control problems, which arise from the transaction costs, are transformed to free boundary and partial differential equation problems. Once the problems have been formulated, we establish optimal trading strategies for each of the portfolios. In addition, the optimal hedging strategies can be found by comparing the trading strategies of the two portfolios. We provide a general procedure for solving N risky assets, which shows that for ‘small’ correlations the N asset problem can be replaced by N ( N − 1)/2 two-dimensional problems and give numerical examples for the two risky assets portfolios.
Date: 2012
References: Add references at CitEc
Citations: View citations in EconPapers (2)
Downloads: (external link)
http://hdl.handle.net/10.1080/1350486X.2011.601919 (text/html)
Access to full text is restricted to subscribers.
Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
HTML/Text
Persistent link: https://EconPapers.repec.org/RePEc:taf:apmtfi:v:19:y:2012:i:2:p:131-179
Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/RAMF20
DOI: 10.1080/1350486X.2011.601919
Access Statistics for this article
Applied Mathematical Finance is currently edited by Professor Ben Hambly and Christoph Reisinger
More articles in Applied Mathematical Finance from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().