Option Pricing and Hedging with Small Transaction Costs
Munich University of Technology
September 18, 2012
Swiss Finance Institute Research Paper No. 12-30
Abstract: An investor with constant absolute risk aversion trades a risky asset with general Itôdynamics, 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 indierence prices and hedging strategies in the presence of small transaction costs.