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Title: Option Pricing with Transaction Costs Using a Markov Chain Approximation
Authors: Monoyios, M
Keywords: Option pricing; transaction costs; utility maximisation; singular;stochastic control; Markov chain approximation
Issue Date: 2001
Publisher: Brunel University
Citation: Economics and Finance Working papers, Brunel University, 01-03
Abstract: An e cient algorithm is developed to price European options in the pres- ence of proportional transaction costs, using the optimal portfolio frame- work of Davis (1997). A fair option price is determined by requiring that an in nitesimal diversion of funds into the purchase or sale of options has a neutral e ect 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 op- tion payo 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 speci ed 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 de nition of an option hedg- ing strategy for a utility maximising investor is developed. This involves calculating the perturbation to the optimal portfolio strategy when an option trade is executed.
Appears in Collections:Dept of Economics and Finance Research Papers

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