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E L S E V IE R
J o u rn a l
o f E c o n o m ic
D y n a m ic s
a n d
C o n tro l
2 1 (1 9 9 7 ) 1 3 5 3 -1 3 7 6
O p tim al
d e lta -h e d g in g
u n d e r
tra n s a c tio n s
c o s ts
L es
C le w lo w * ,
S te w a rt
H odges
F in a n c ia l
O p tio n s
R e s e a r c h
C entre.
W arw ick
B u s in e s s
S c h o o l,
T h e
U n iv e r s ity
o f
W arw ick,
C oventry
C V 4
7 A L ,
U K
A b str a c t
T h is p a p e r
e x a m in e s
th e p ro b le m
o f d e lta -h e d g in g
p o rtfo lio s
o f o p tio n s
u n d e r
tra n s a c -
tio n s
c o s ts
by m axim ising
e x p e c te d
u tility
(o r m in im isin g
a lo s s fu n c tio n
o n
th e
re p lic a -
tio n
e r r o r ) .
W e e x te n d
th e
w ork
of H odges
a n d
N euberger
(1 9 8 9 ) to
s tu d y
th e
o p tim a l
s tra te g y
u n d e r
a
g e n e ra l
c o s t
fu n c tio n
w ith
fix e d
a n d
p ro p o rtio n a l
c o s ts .
A
c o m p u ta -
tio n a l
p ro c e d u re
fo r
s o lv in g
th is
p ro b le m
is
d e s c rib e d
a n d
w e
d e v e lo p
a n
e ffic ie n t
c o m p u ta tio n a l
m e th o d
fo r th e
c a s e
o f p ro p o rtio n a l
tra n s a c tio n
costs. W e
e x a m in e
th e
n a tu re
o f th e
s o lu tio n
c lo s e
t o
th e
e x p iry
d a te
a n d
u s in g
sim u latio n
w e com pare
th e
perform ance
o f th e
o p tim a l
s tra te g ie s
w ith
o th e r
com m on
s tra te g ie s .
K eyw ords:
O p tio n
p ric in g ;
H e d g in g ;
T ra n s a c tio n
c o s ts ;
C o m p u ta tio n a l
m ethods;
S im u la tio n
JE L
c la s s ~ c a tio n :
G 13; C 61
1 . I n tr o d u c tio n
T h is p a p e r
d e s c rib e s
a s to c h a s tic
o p tim a l
c o n tro l
a p p ro a c h
fo r d e lta -h e d g in g
p o rtfo lio s
o f c o n tin g e n t
claim s
i n
th e
p re s e n c e
o f tra n s a c tio n
c o s ts .
It e x te n d s
* C o rre sp o n d in g a u th o r.
T he
a u th o rs
w o u ld
like to
a c k n o w le d g e
h e lp fu l
d is c u s s io n s
w ith
M ic h a e l
S e lb y , C h ris
S tric k la n d ,
S ih o
A p a ric io ;
p a rtic ip a n ts
i n
th e
F in a n c ia l
O p tio n s
R esearch
C en tre\u2019s
F ifth
a n n u a l
C onference
(Ju n e
1 9 9 2 ), p a rtic u la rly
M ic h a e l
D em pster;
a n d
th e
E u ro p e a n
F in a n c e
A s s o c ia tio n
c o n fe re n c e
i n
C openhagen,
A ugust
1 9 9 3 , p a rtic u la rly
C o n s ta n tin e
T h a n a s s o u la s
a n d
R am an
U p p a l;
a n d
a n
anonym ous
referee. A ll errors
rem ain
o u r
o w n . F u n d in g
fo r th is
w ork
w a s p ro v id e d
by past
a n d
p re s e n t
c o rp o ra te
m em bers
o f
th e
F in a n c ia l
O p tio n s
R esearch
C e n tre :
B ankers
T ru st,
B anque
In d o s u e z ,
C red it
Suisse First
B o s to n ,
K lein w o rt
B enson
Investm ent
M a n a g e m e n t,
L IF F E /L T O M ,
L o n d o n
C le a rin g
House, London
C o m m o d ity
E x c h a n g e ,
H S B C
M arkets,
T o k y o
M itsu b ish i
In te r-
n a tio n a l,
D eutsche
M organ
G ren fell,
N om ura
Bank, SBC
W arburgs,
U B S
P h illip s
a n d
D rew .
0 1 6 % 1 8 8 9 /9 7 /% 1 7 .0 0 0
1 9 9 7 E ls e v ie r
S c ie n c e
B .V . A ll rig h ts
re s e rv e d
P II
S O 1 6 5 -1 8 8 9 (9 7 )0 0 0 3 0 -4
1 3 5 4
L .
C le w lo w ,
S. Hodges
J Journal
o fE c o n o n z ic
D y n a m ic s
a n d
C o n tr o l
2 1
(1 9 9 7 )
1 3 5 3 -1 3 7 6
e a rlie r
w ork
by Hodges
a n d
N euberger
(1 9 8 9 ), w h o
a n a ly s e d
the case of writing
a n d
h e d g in g
a European
c a ll o p tio n
u n d e r
p ro p o rtio n a l
costs. In
th is p a p e r
w e
s tu d y
th e
o p tim a l
s tra te g ie s
u n d e r
a general
c o s t
fu n c tio n
w ith
a constant
c o s t
p e r tra n s a c tio n ,
a cost per unit of asset transacted
a n d
a c o s t p ro p o rtio n a l
to the
v a lu e
tra n s a c te d .
W e analyse
th e n a tu re
o f th e
s tra te g ie s
th ro u g h
tim e in c lu d in g
c lo s e
t o
th e
s e ttle m e n t
d a te
w here
th e
ty p e
o f s e ttle m e n t,
e ith e r
a s s e t
o r
c a s h
s e ttle m e n t,
h a s
a s ig n ific a n t
effect. The
c o m p u ta tio n a l
m e th o d
fo r s o lv in g
th is
p ro b le m
is described
in d e ta il a n d
a n e ffic ie n t c o m p u ta tio n a l
m e th o d
to solve for
th e
o p tim a l
s tra te g ie s
u n d e r
p ro p o rtio n a l
tra n s a c tio n
c o s ts
is d e v e lo p e d .
T h e n ,
u s in g s im u la tio n ,
w e com pare
th e p e rfo rm a n c e
o f th e
o p tim a l
s tra te g ie s
a g a in s t
ty p ic a l
s u b -o p tim a l
s tra te g ie s
s u c h
a s B la c k -S c h o le s
a n d
L e la n d
for a variety
o f
p o rtfo lio s
o f m ix e d
lo n g
a n d
sh o rt
p o s itio n s .
T h e c o n s tru c tio n
o f h e d g in g
s tra te g ie s
w h ic h
b e s t re p lic a te
th e o u tc o m e s
fro m
p o rtfo lio s
o f o p tio n s
(a n d
o th e r
c o n tin g e n t
claim s)
i n
th e
p re s e n c e
of transac-
tio n s
c o s ts
is an
im p o rta n t
p ro b le m .
H e d g in g
is c e n tra l
t o
th e
th e o ry
o f o p tio n
p ric in g .
A rb itra g e
v a lu a tio n
m odels,
s u c h
a s th a t
o f B la c k
a n d
S c h o le s
(1 9 7 3 ),
d e p e n d
o n
th e
id e a
th a t
a n
o p tio n
c a n
b e p e rfe c tly
h e d g e d
u s in g
th e u n d e rly in g
a s s e t,
s o
m a k in g
it possible
t o
c re a te
a
p o rtfo lio
w h ic h
re p lic a te s
th e
o p tio n
e x a c tly . H e d g in g
is also w idely
used to reduce
risk, and
th e k in d
o f d e lta -h e d g in g
s tra te g ie s
im p licit
in Black
a n d
S c h o le s
a re
c o m m o n ly
a p p lie d ,
at least approx-
im a te ly ,
b y
p a rtic ip a n ts
i n
o p tio n s
m arkets.
O p tim al
h e d g in g
s tra te g ie s
a re
th e re fo re
o f d ire c t
p ra c tic a l
in te re s t.
M uch
o f th e th e o ry
o f o p tio n s
assum es
th a t
m a rk e ts
are frictionless.
T h is p a p e r
c o n s id e rs
th e im p a c t
o f tra n s a c tio n s
c o s ts
o n
d e lta -h e d g in g
a n d
v a lu a tio n .
This is closely
re la te d
to th e v a lu a tio n
is s u e s w h ic h
a r is e
w here
th e
n a tu re
o f th e
m arket
d ic ta te s
th a t
tra d in g
is d is c o n tin u o u s ,
o r
th a t
th e
a s s e t
p ro c e s s
i s
s u c h
th a t
th e
m arket
is in c o m p le te
a n d
c o n tin g e n t
claim s
a re
n o t
s p a n n e d
b y
e x is tin g
s e c u ritie s .
T he
first paper
to c o n s id e r
th e
p ro b le m
o f re p lic a tin g
o p tio n s \u2019
p a y o ffs
u s in g
d e lta -h e d g in g
u n d e r
tra n s a c tio n s
c o s ts
w as
L e la n d
(1 9 8 5 ). T h e
is s u e
is parti-
c u la rly
in te re s tin g
b e c a u s e
u n d e r
th e
u s u a l
B la c k -S c h o le s
s tra te g y ,
im p le -
m e n te d
a s re b a la n c in g s
a t d is c re te
in te rv a ls ,
th e e x p e c te d
v o lu m e
o f tra n s a c tio n s
becom es
u n b o u n d e d
a s
th e
num ber
o f
re b a la n c in g s
i s
in c re a s e d .
L e la n d \u2019s
a n a ly s is
i s
s e t
i n
a
c o n tin u o u s -tim e
fram ew o rk
a n d
assum es
p ro p o rtio n a l
tra n s a c tio n s
c o s ts .
It describes
h o w
b y
m a k in g
a n
a d ju s tm e n t
t o
th e
v a ria n c e
(w h ich
d e p e n d s
o n
th e
e x o g e n o u s ly
s p e c ifie d
re v is io n
fre q u e n c y )
th e
B la c k -S c h o le s
fo rm u la
c a n
b e
u s e d
t o
h e d g e
w ith
a zero
e x p e c te d
re p lic a tio n
e rro r,
a n d
w ith
a standard
d e v ia tio n
w h ic h
te n d s
to zero
w ith
th e le n g th
o f th e
re b a la n c in g
in te rv a l.
N euhaus
(1 9 8 9 ) c o n trib u te s
som e
fu rth e r
th e o re tic a l
in -
s ig h ts
t o
th is
a p p ro a c h .
T he
m e th o d
d e s c rib e d
i n
th is
p a p e r
fo llo w s
e a rlie r
w ork
b y
H odges
a n d
N euberger
(1989) and
is based
on m axim ising
e x p e c te d
u tility .
A lte rn a tiv e ly ,
w e
m ay
v ie w
it a s m in im isin g
a lo s s fu n c tio n
d e fin e d
o n
th e
re p lic a tio n
e rro r.
T h is
a p p ro a c h
seem s m ore
a p p ro p ria te
th a n
e x a c t
re p lic a tio n
s in c e it p ro v id e s
m uch
L
C h ~ lo ll~ , S . H o d g es
/ Jo u rn a l
o f E co n o m ic
D .v n a m i c s a n d
C ortfrol 21
(1 9 9 7 )
1 3 5 3 - 1 3 7 6
1 3 5 5
tig h te r
v a lu a tio n
b o u n d s .
D e p e n d in g
o n
th e
c h o ic e
of risk-aversion
param eter
w e
c a n
o b ta in
e ith e r
tig h t
o r
m uch
lo o s e r
(b u t
a ls o
c h e a p e r)
h e d g in g .
T he
a p p ro a c h
is in a p a ra d ig m
sim ilar
t o
th a t
o f D a v is
(1 9 8 8 )
D a v is
a n d
N orm an
(1 9 8 8 )
T a k s a r
e t
a l.
(1 9 8 8 )
a n d
D um as
a n d
L u c ia n o
(1 9 9 1 ).
T h e s e
p a p e rs
d e s c rib e
o p tim a l
p o rtfo lio
s tra te g ie s
to m ax im ise
e x p e c te d
u tility
o v e r
a n in fin ite
h o riz o n .
T h e y
e x te n d
e a rlie r
w ork
b y M e rto n
(1971) and
C o n s ta n tin id e s
(1 9 8 6 ).
H ow ever,
w h ile
th e s e
p a p e rs
a re
c o n c e rn e d
w ith
o p tim a l
p o rtfo lio
s tra te g ie s ,
th e y
a re
n o t
d ire c tly
c o n c e rn e d
w ith
th e
p ro b le m s
o f re p lic a tin g
(o r
sim ilarly
h e d g in g )
c o n tin g e n t
claim s
b y
m eans
o f th e
u n d e rly in g
a s s e t.
M e n tio n
s h o u ld
a ls o
be made
of a num ber
o f o th e r
re c e n t
p a p e rs
re la te d
t o
o u rs.
T he
m odel
f ir s t
p ro p o s e d
b y
H odges
a n d
N euberger
(1 9 8 9 )
h a s
b e e n
fu rth e r
s tu d ie d
b y D a v is
a n d
P a n a s
(1 9 9 1 )
a n d
D a v is
e t a l. (1 9 9 3 ). D ix it
(1 9 9 1 )
a n d
D um as
(1 9 9 1 ) p ro v id e
useful m aterial
o n s m o o th
p a s tin g
c o n d itio n s
w h ic h
u s u a lly
a p p ly
t o
p ro b le m s
s u c h
as ours. Figlew ski (1987) gives som e
in te re s tin g
sim u latio n
r e s u lts .
B o y le
a n d
V o rst
(1 9 9 2 ) p ro v id e
a n
e le g a n t
re w o rk in g
o f
L e la n d \u2019s
a n a ly s is
w ith in
a b in o m ia l
fram ew ork.
T h is h a s th e
fo llo w in g
in te re s t-
in g fe a tu re .
T h e ir
v a ria n c e
a d ju s tm e n t
differs from
L e la n d \u2019s , e s s e n tia lly
b e c a u s e
th e
b in o m ia l
a s s u m p tio n
d is to rts
th e
e x p e c te d
a b s o lu te
p ric e
c h a n g e
i n
a n y
s u b -in te rv a l
e v e n
th o u g h
it p ro v id e s
th e c o rre c t
v a ria n c e .
W ilm o tt
(1 9 9 3 , 1 9 9 4 )
fu rth e r
a n a ly s e s
a p p ro a c h e s
b a s e d
o n h e d g in g
a t d is c re te
in te rv a ls .
E d iris in g h e ,
N a ik
a n d
U ppal
(1 9 9 3 ) a ls o p ro v id e
a b in o m ia l
re p lic a tio n
b a s e d
a p p ro a c h ,
a n d
a p p ly
a te c h n o lo g y
b a s e d
o n lin e a r
p ro g ra m m in g .
R e p lic a tio n
c a n
be a danger-
o u s
p h ilo s o p h y .
B ensaid
et al. (1992), also
i n
a discrete-tim e
fram ew ork,
s h o w
th a t it c a n b e c h e a p e r
to d o m in a te
a c o n tin g e n t
c la im
th a n
to e x a c tly
re p lic a te
i t .
C o n s ta n tin id e s
a n d
Z a rip h o p o u lo u
(1 9 9 5 )
o b ta in
m uch
tig h te r
v a lu a tio n
b o u n d s
b y
m ax im isin g
e x p e c te d
u tility
th a n
c a n
b e o b ta in e d
b y
e ith e r
re p lic a -
tio n
o r d o m in a n c e
o b je c tiv e s .
I n
c o n tra s t,
N euberger
(1994) show s
th a t
u n d e r
a p u re
jum p
p ro c e s s
(w ith
fixed jum p
size), exact
re p lic a tio n
c a n
p ro v id e
tig h t
b o u n d s
o n
o p tio n
v a lu e s .
S e c tio n
2 of the
p a p e r
in tro d u c e s
th e
m o d e l,
b a s e d
c lo s e ly
o n
H odges
a n d
N euberger
(1989), describes
th e
g e n e ra l
p ro b le m
o f th e
b e s t
re p lic a tio n
of a
c o n tin g e n t
c la im
(o r p o rtfo lio
o f c la im s ) u n d e r
tra n s a c tio n s
costs, and
d e v e lo p s
th e
s o lu tio n
a p p ro a c h
we have
a d o p te d .
S e c tio n
3 describes
th e
c o m p u ta tio n a l
p ro c e d u re .
I n
S e c tio n
4 we discuss
th e
p ro p e rtie s
o f th e
o p tim a l
s tra te g ie s
fo r
b o th
p ro p o rtio n a l
c o s ts o n ly
and a general cost function.
O u r s im u la tio n
a n a ly s is ,
in S e c tio n
5, com pares
th e
h e d g in g
perform ance
o f a v a rie ty
of approaches
t o
h e d g e
a s m a ll s e le c tio n
o f o p tio n
e x p o s u re s .
S e c tio n
6 presents
o u r
c o n c lu s io n s .
2 .
T he
m odel
T he
stru c tu re
o f th e
m odel
fo llo w s
th a t
d e v e lo p e d
in H o d g e s
a n d
N euberger
(1 9 8 9 ). D a v is
a n d
P a n a s
(1991) and
D a v is e t a l. (1 9 9 3 ) h a v e d e v e lo p e d
so m e of its
of 00

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