The Mathematical Institute, University of Oxford, Eprints Archive

Option pricing with transaction costs using a Markov chain approximation

Monoyios, Michael (2004) Option pricing with transaction costs using a Markov chain approximation. Journal of Economic Dynamics and Control, 28 . pp. 889-913.

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Abstract

An efficient algorithm is developed to price European options in the presence of proportional transaction costs, using the optimal portfolio framework of Davis (in: Dempster, M.A.H., Pliska, S.R. (Eds.), Mathematics of Derivative Securities. Cambridge University Press, Cambridge, UK). A fair option price is determined by requiring that an infinitesimal diversion of funds into the purchase or sale of options has a neutral effect on achievable utility. This results in a general option pricing formula, in which option prices are computed from the solution of the investor's basic portfolio selection problem, without the need to solve a more complex optimisation problem involving the insertion of the option payoff into the terminal value function. Option prices are computed numerically using a Markov chain approximation to the continuous time singular stochastic optimal control problem, for the case of exponential utility. Comparisons with approximately replicating strategies are made. The method results in a uniquely specified option price for every initial holding of stock, and the price lies within bounds which are tight even as transaction costs become large. A general definition of an option hedging strategy for a utility maximising investor is developed. This involves calculating the perturbation to the optimal portfolio strategy when an option trade is executed.

Item Type:Article
Subjects:O - Z > Partial differential equations
O - Z > Probability theory and stochastic processes
A - C > Calculus of variations and optimal control
Research Groups:Mathematical and Computational Finance Group
ID Code:232
Deposited By:Michael Monoyios
Deposited On:24 May 2006
Last Modified:20 Jul 2009 14:19

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