Leland's Approximations for Concave Pay-off Functions

Emmanuel Denis
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Emmanuel Denis: School of Management, Boston University, USA

Chapter 6 in Recent Advances in Financial Engineering, 2009, pp 107-117 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractIn 1985, Leland suggested an approach to pricing contingent claims under proportional transaction costs. Its main idea is to use the classical Black–Scholes formula with a suitably enlarged volatility for a periodically revised portfolio which terminal value approximates the pay-off h(ST). In subsequent studies, Lott (for α = 1/2), Kabanov and Safarian proved that for the call-option, i.e. for h(x) = (x-K)+, Leland's portfolios, indeed, approximate the pay-off if the transaction costs coefficients decreases as n-α for α ∈ ]0, 1/2] where n is the number of revisions. These results can be extended to the case of more general pay-off functions and non-uniform revision intervals [1]. Unfortunately, the terminal values of portfolios do not converge to the pay-off if h is not a convex function. In this paper, we show that we can slightly modify the Leland strategy such that the convergence holds for a large class of concave pay-off functions if α = 1/2.

Keywords: Financial Engineering; Mathematical Finance; Real Options; Credit Risk; Option Pricing; Transaction Cost; Market Microstructure (search for similar items in EconPapers)
Date: 2009
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