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Option Hedging with Transaction Costs

Luoma, Sonja (2010)
Department of Economics
Abstract
This thesis explores how transaction costs affect the optimality of hedging when using Black-Scholes option pricing model. Further, a number of models developed to improve the hedging results of Black-Scholes, when accounting for transaction costs, are analysed and compared. To numerically evaluate these strategies, extensive Monte-Carlo simulations are generated and the results of the strategies are computed in risk-return frameworks. The general finding is that the variable bandwidth delta and fixed bandwidth delta strategy showed the best results, whereas Black-Scholes model expectedly generated poor results. However, slightly unpredictably the asset tolerance strategy did not outperform the Black-Scholes strategy. While an overall... (More)
This thesis explores how transaction costs affect the optimality of hedging when using Black-Scholes option pricing model. Further, a number of models developed to improve the hedging results of Black-Scholes, when accounting for transaction costs, are analysed and compared. To numerically evaluate these strategies, extensive Monte-Carlo simulations are generated and the results of the strategies are computed in risk-return frameworks. The general finding is that the variable bandwidth delta and fixed bandwidth delta strategy showed the best results, whereas Black-Scholes model expectedly generated poor results. However, slightly unpredictably the asset tolerance strategy did not outperform the Black-Scholes strategy. While an overall ranking between the hedging approaches could be defined, the optimal strategy and the relative difference between the strategies varied with the level of risk aversion. (Less)
Please use this url to cite or link to this publication:
@misc{1607212,
  abstract     = {This thesis explores how transaction costs affect the optimality of hedging when using Black-Scholes option pricing model. Further, a number of models developed to improve the hedging results of Black-Scholes, when accounting for transaction costs, are analysed and compared. To numerically evaluate these strategies, extensive Monte-Carlo simulations are generated and the results of the strategies are computed in risk-return frameworks. The general finding is that the variable bandwidth delta and fixed bandwidth delta strategy showed the best results, whereas Black-Scholes model expectedly generated poor results. However, slightly unpredictably the asset tolerance strategy did not outperform the Black-Scholes strategy. While an overall ranking between the hedging approaches could be defined, the optimal strategy and the relative difference between the strategies varied with the level of risk aversion.},
  author       = {Luoma, Sonja},
  keyword      = {transaction costs,Black-Scholes,Geometric Brownian Motion,Option Hedging,Monte-Carlo Simulations,Economics, econometrics, economic theory, economic systems, economic policy,Nationalekonomi, ekonometri, ekonomisk teori, ekonomiska system, ekonomisk politik},
  language     = {eng},
  note         = {Student Paper},
  title        = {Option Hedging with Transaction Costs},
  year         = {2010},
}