Option Pricing and Hedging with Small Transaction Costs

Research paper by Jan Kallsen, Johannes Muhle-Karbe

Indexed on: 12 Dec '12Published on: 12 Dec '12Published in: arXiv - Quantitative Finance - Pricing of Securities


An investor with constant absolute risk aversion trades a risky asset with general It\^o-dynamics, in the presence of small proportional transaction costs. In this setting, we formally derive a leading-order optimal trading policy and the associated welfare, expressed in terms of the local dynamics of the frictionless optimizer. By applying these results in the presence of a random endowment, we obtain asymptotic formulas for utility indifference prices and hedging strategies in the presence of small transaction costs.