Option Replication in Discrete Time with Illiquidity

Koichi Matsumoto

Applied Mathematical Finance, 2013, vol. 20, issue 2, 167-190

Abstract: This article studies a replication of a contingent claim in an illiquid market. We represent the liquidity as a supply curve in a discrete time model. Because the trade price of the illiquid asset is a function of the trade size in this model, it is important whether the contingent claim is physically settled or settled in cash. In both cases, we give a condition where a replication strategy exists uniquely and show some properties of the replication strategy. Further we analyse the liquidity cost numerically.

Date: 2013
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DOI: 10.1080/1350486X.2012.675161

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