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Hedging errors with Leland's option model in the presence of transaction costs [An article from: Finance Research Letters]
Book Details
Author(s)Y. Zhao, W.T. Ziemba
PublisherElsevier
ISBN / ASINB000PDTX6Y
ISBN-13978B000PDTX64
AvailabilityAvailable for download now
MarketplaceUnited States 🇺🇸
Description
This digital document is a journal article from Finance Research Letters, published by Elsevier in 2007. The article is delivered in HTML format and is available in your Amazon.com Media Library immediately after purchase. You can view it with any web browser.
Description:
Nonzero transaction costs invalidate the Black-Scholes [1973. Journal of Political Economy 81, 637-654] arbitrage argument based on continuous trading. Leland [1985. Journal of Finance 40, 1283-1301] developed a hedging strategy which modifies the Black-Scholes hedging strategy with a volatility adjusted by the length of the rebalance interval and the rate of the proportional transaction cost. Kabanov and Safarian [1997. Finance and Stochastics 1, 239-250] calculated the limiting hedging error of the Leland strategy and pointed out that it is nonzero for the approximate pricing of an European call option, in contradiction to Leland's claim. As a further contribution, we first identify the mathematical flaw in the argument of Leland's claim and then quantify the expected percentage of hedging losses in terms of the hedging frequency and the level of the option strike price.
Description:
Nonzero transaction costs invalidate the Black-Scholes [1973. Journal of Political Economy 81, 637-654] arbitrage argument based on continuous trading. Leland [1985. Journal of Finance 40, 1283-1301] developed a hedging strategy which modifies the Black-Scholes hedging strategy with a volatility adjusted by the length of the rebalance interval and the rate of the proportional transaction cost. Kabanov and Safarian [1997. Finance and Stochastics 1, 239-250] calculated the limiting hedging error of the Leland strategy and pointed out that it is nonzero for the approximate pricing of an European call option, in contradiction to Leland's claim. As a further contribution, we first identify the mathematical flaw in the argument of Leland's claim and then quantify the expected percentage of hedging losses in terms of the hedging frequency and the level of the option strike price.
