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**3 (July 1997), 307–324
**

AN ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL FOR

OPTION PRICING WITH TRANSACTION COSTS

A. E. WHALLEY

Mathematical Institute, Oxford University

P. WILMOTT

∗

Mathematical Institute, Oxford University

and

Department of Mathematics, Imperial College, London

Davis, Panas, and Zariphopoulou (1993) and Hodges and Neuberger (1989) have presented a very

appealing model for pricing European options in the presence of rehedging transaction costs. In their

papers the ‘maximization of utility’ leads to a hedging strategy and an option value. The latter is

different from the Black–Scholes fair value and is given by the solution of a three-dimensional free

boundary problem. This problem is computationally very time-consuming. In this paper we analyze

this problemin the realistic case of small transaction costs, applying simple ideas of asymptotic analysis.

The problemis then reduced to an inhomogeneous diffusion equation in only two independent variables,

the asset price and time. The advantages of this approach are to increase the speed at which the optimal

hedging strategy is calculated and to add insight generally. Indeed, we ﬁnd a very simple analytical

expression for the hedging strategy involving the option’s gamma.

KEY WORDS: option pricing, transaction costs, asymptotic analysis, nonlinear diffusion

1. INTRODUCTION

Option pricing in the presence of transaction costs has recently become a very popular

subject for research. There are two main approaches to this work in the literature: local in

time and global in time. The former was started by Leland (1985) and extended by Boyle

and Vorst (1992), Hoggard, Whalley, and Wilmott (1994) and Whalley and Wilmott (1993).

The ﬁrst three of these assume hedging takes place at given discrete intervals (Boyle and

Vorst is actually a binomial model) and the last assumes ﬂexible trading periods. In all cases

the decision whether or not to rehedge is based on minimizing the current level of risk as

measured by the variance of the hedged portfolio. Such models are often used in practice

and are invariably quick to compute. They typically result in two-dimensional nonlinear or

inhomogeneous diffusion equations for the value of an option. The global-in-time models

can be illustrated by the model of Hodges and Neuberger (1989) and Davis, Panas, and

Zariphopoulou (1993). Such models achieve an element of ‘optimality,’ since they are

based on the approach of utility maximization. The appeal of optimality is obvious, but, on

the other hand, such models do have a number of disadvantages. Two of these disadvantages

are speed of computation and the necessity of prescribing the investor’s utility function.

∗

This author thanks the Royal Society for its support.

Manuscript received January 1994; ﬁnal revision received July 1995.

Address correspondence to Paul Wilmott, Centre for Industrial and Applied Mathematics, Oxford University,

24-29 St. Giles, Oxford, OX1 3LB, UK.

c 1997 Blackwell Publishers, 350 Main St., Malden, MA 02148, USA, and 108 Cowley Road, Oxford,

OX4 1JF, UK.

307

308 A. E. WHALLEY AND P. WILMOTT

The models are slow to compute since they usually result in three- or four-dimensional free

boundary problems. There is great practitioner resistance to the idea of utility theory.

In this paper we perform a simple asymptotic analysis of the Davis, Panas, and Za-

riphopoulou (1993) model. We show how, in the limit of small transaction costs, their

three-dimensional free boundary problem reduces to a much simpler two-dimensional in-

homogeneous diffusion equation of the form found in the local-in-time models. We thus

bring together the competing philosophies behind modeling transaction costs. The asymp-

totic formulas for the hedging strategy we present here have been tested empirically by

Mohamed (1994), and found to be the best strategy he tested.

Perturbation analysis is a very powerful tool of applied mathematics. It is used to great

effect in areas such as ﬂuid mechanics (Hinch 1991), because it reveals the salient features of

the problemwhile remaining a good approximation to the full but more complicated model.

As yet, the technique has, to our knowledge, rarely been used in ﬁnance. For this reason,

we shall at times walk the reader very slowly through the calculations. For comparison,

for an asymptotic analysis of the Morton and Pliska (1995) portfolio management problem

with transaction costs, see Atkinson and Wilmott (1993).

In Section 2 we very brieﬂy describe the model of Davis, Panas, and Zariphopoulou

(1993), the interested reader should read that paper carefully in conjunction with this. In

Section 3 we consider the asymptotic limit of small transaction costs. This results in an

inhomogeneous diffusion equation for the price of an option. In Section 4 we compare the

model with others and draw conclusions.

Recall that in the absence of transaction costs the Black–Scholes equation for the value

of an option is

W

t

+r SW

S

+

σ

2

S

2

2

W

SS

−r W = 0. (1.1)

Here S is the underlying asset price, t is time, r the interest rate, assumed deterministic, σ

the volatility of the underlying, and W(S, t ) is the value of an option. This equation must be

solved for t < T and 0 ≤ S < ∞. On t = T we must impose a ﬁnal condition, amounting

to the payoff function for the option in question. For example, for a call option with strike

price E we have

W(S, T) = max(S − E, 0).

This is the problemto be solved in the absence of costs. In the presence of costs, we shall

ﬁnd an equation similar to the Black–Scholes equation but with additional small terms that

allow for the cost of rehedging and that are nonlinear in the option’s gamma. In common

with the Davis, Panas, and Zariphopoulou paper, we are initially considering the valuation

of a short European call option. We shall continue to use W to denote the Black–Scholes

value of a European option.

2. THE MODEL OF DAVIS, PANAS, AND ZARIPHOPOULOU

In the model of Davis, Panas, and Zariphopoulou (1993) the writing price of a European

option is deﬁned in terms of a utility maximization problem. Simply put, the option price

(to the writer) is obtained by a comparison of the maximum utilities of trading with and

without the obligation of fulﬁlling the option contract at expiry. When there are no costs

this results in the Black–Scholes value for the option (Black and Scholes 1973).

ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 309

The asset price S is assumed to follow the random walk

dS = µS dt +σ S d X,

where µ and σ are constant and X is a Brownian motion.

When the utility function takes the special form U(x) = 1 −exp(−γ x) (so that γ is the

index of risk aversion) Davis et al. ﬁnd that the option price V(S, t ) is given by

V(S, t ) =

δ(T, t )

γ

log

Q

w

(S, 0, t )

Q

1

(S, 0, t )

, (2.1)

where T is the expiry date, δ(T, t ) = e

−r(T−t )

, and Q

1

(S, y, t ) and Q

w

(S, y, t ) both satisfy

the following equation

min

¸

∂ Q

∂y

+

γ (1 +)SQ

δ

, −

∂ Q

∂y

−

γ (1 −)SQ

δ

,

∂ Q

∂t

+µS

∂ Q

∂S

+

σ

2

S

2

2

∂

2

Q

∂S

2

¸

= 0.

Here measures the transaction costs: A trade of N shares will result in a loss of NS.

This cost structure represents bid–offer spread,

1

or more generally commissions and costs

that are proportional to the value of the assets traded. The independent variable y measures

the number of shares held in the optimally hedged portfolio. The two functions Q

1

and

Q

w

must satisfy certain ﬁnal conditions, analogous to the payoff proﬁle of the option; for

example, for a call option

Q

1

(S, y, T) = exp(−γ c(S, y)) (2.2)

and

Q

w

(S, y, T) =

¸

exp(−γ c(S, y)) S ≤ E

exp(−γ (c(S, y) + E − S)) S > E

(2.3)

where

c(S, y) =

¸

(1 +)yS y < 0

(1 −)yS y ≥ 0.

So the ﬁnal condition for the second problem (with subscript w) is equal to that of the ﬁrst

problem (with subscript 1) modiﬁed by the effects of the potential liability at expiry of the

European call (after transaction costs). Note we are assuming here that the option is settled

in cash. For options with delivery of the asset on exercise the analysis below remains the

same; the ﬁnal conditions merely alter.

Finally, to fully pose the problem we must specify that for t < T, Q, ∂ Q/∂S, and

∂

2

Q/∂S

2

must all be continuous.

1

Davis et al. consider the slightly more general case in which there are different levels of cost for buying and

selling.

310 A. E. WHALLEY AND P. WILMOTT

FIGURE 2.1. A schematic diagram of (S, y) space showing the buy, sell, and no-transaction

regions.

This is a free boundary problem. It is explained by Davis et al. how the (S, y) space

divides into three regions, shown schematically in Figure 2.1. The writer of the option

must always maintain his portfolio in the region of the (S, y) space bounded by the two

outer curves, while inside this region he does not transact. Should a movement of the asset

price take the writer to the edge of this no-transaction region he must trade so as to just stay

inside. If he hits the top boundary he must sell shares, if he hits the bottom boundary he

must buy shares. The middle line in Figure 2.1 is the curve along which the investor must

move in the absence of transaction costs; this curve is denoted by

y = y

∗

(S, t ).

Both y

∗

and the position of the upper and lower boundaries are to be found. We shall ﬁnd

simple analytical expressions for all three of these curves.

In the buy region we have

∂ Q

∂y

+

γ (1 +)SQ

δ

= 0. (2.4)

In the sell region we have

∂ Q

∂y

+

γ (1 −)SQ

δ

= 0. (2.5)

ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 311

In the no-transaction region we have

∂ Q

∂t

+µS

∂ Q

∂S

+

σ

2

S

2

2

∂

2

Q

∂S

2

= 0. (2.6)

This is the free boundary problem we shall shortly solve asymptotically. Because the two

problems for Q

1

and Q

w

are identical except for the ﬁnal data, we need only perform the

analysis for one of them. When we come to apply the ﬁnal data we will distinguish between

Q

1

and Q

w

as necessary. As mentioned above, across the two free boundaries (the outer

curves in Figure 2.1) Q, ∂ Q/∂S, and ∂

2

Q/∂S

2

must all be continuous.

3. ASYMPTOTIC ANALYSIS FOR SMALL LEVELS OF TRANSACTION COSTS

Equation (2.4) is very easy to solve explicitly. The solution for Q(S, y, t ) in the buy region

is found to be

Q = exp

−

γ Sy

δ

−

γ Sy

δ

+ H

−

(S, t ; )

(3.1)

where H

−

is, as yet, an arbitrary function of S and t that comes from solving the ordinary

differential equation (2.4): in this equation S and t are effectively parameters.

In the sell region we can similarly solve (2.5) to get

Q = exp

−

γ Sy

δ

+

γ Sy

δ

+ H

+

(S, t ; )

. (3.2)

This contains another arbitrary function H

+

. The two expressions (3.1) and (3.2) are the

exact, general solutions of (2.4) and (2.6).

The solution in the no-transaction region is much harder to ﬁnd. Indeed, we shall not ﬁnd

the general solution, rather we shall ﬁnd the asymptotic solution valid for small . The ﬁrst

stage in determining this solution is to expand Q in an asymptotic series in powers of .

We write the solution in the no-transaction region as

Q = exp

−

γ Sy

∗

δ

+ H

0

(S, t ) −

1/3

γ SY

δ

+

1/3

H

1

(S, t ) +

2/3

H

2

(S, t ) (3.3)

+ H

3

(S, t ) +

4/3

H

4

(S, Y, t ) +

5/3

H

5

(S, Y, t ) +· · ·

.

There are two very important things to note about this expression. First, we have chosen

to expand in powers of

1/3

. This is not an arbitrary choice. As we performour analysis, we

shall see how such a choice is the natural one. (Shreve and Soner, 1994, have results that

suggest a similar asymptotic scale for the width of the no-transaction interval for an optimal

investment and consumption model with transaction costs under a different utility function,

and notes that Fleming, Grossman, Vila, and Zariphopoulou (1990) have also obtained this

312 A. E. WHALLEY AND P. WILMOTT

scale.) Second, we have translated the y coordinate according to

y = y

∗

(S, t ) +

1/3

Y. (3.4)

Thus Y is a rescaled variable (see Figure 2.1). It is a measure of the difference between the

number of shares actually held in the portfolio and the ideal number we would hold in the

absence of transction costs, y

∗

. We shall ﬁnd an explicit expression for y

∗

as a function of

S and t . Y turns out to be a more natural variable to use than y. The factor of

1/3

represents

the scale of the asymptotic width of the no-transaction region for this type of transaction

costs (proportional to value traded).

Observe how, in (3.3), there is Y dependence at O(

1/3

) and O(

4/3

). The former is

forced by the leading terms in (3.1) and (3.2) and continuity of slope at the boundary of

the no-transaction region. The reason for the latter is similar and the details will become

apparent. It is such continuity requirements that actually force on us the special choice

of

1/3

.

As yet (3.3) does not satisfy the equation in the no-transaction region. We must now

ﬁnd the functions H

i

such that this equation and all relevant boundary and smoothness

conditions are satisﬁed. We shall see, in performing this analysis, that the choice of a series

expansion in powers of

1/3

is inevitable.

Since the derivatives in (2.6) are with respect to t and S keeping y ﬁxed, then

∂

∂y

→

−1/3

∂

∂Y

,

∂

∂S

→

∂

∂S

−

−1/3

y

∗

S

∂

∂Y

,

∂

∂t

→

∂

∂t

−

−1/3

y

∗

t

∂

∂Y

.

Thus we readily ﬁnd from (3.3) and (3.4) that

∂ Q

∂t

≡ Q

t

=

−

γ Sy

∗

t

δ

+ H

0

t

(S, t ) +

rγ Sy

∗

δ

+

1/3

rγ SY

δ

+

1/3

H

1

t

(S, t ) +

2/3

H

2

t

(S, t ) +H

3

t

(S, t )

+

4/3

H

4

t

(S, Y, t ) + y

∗

t

γ S

δ

−H

4

Y

+· · ·

Q,

∂ Q

∂S

≡ Q

S

=

−

γ Sy

∗

S

δ

+ H

0

S

(S, t ) −

γ y

∗

δ

−

1/3

γ Y

δ

+

1/3

H

1

S

(S, t ) +

2/3

H

2

S

(S, t ) +H

3

S

(S, t )

+

4/3

H

4

S

(S, Y, t ) + y

∗

S

γ S

δ

−H

4

Y

+· · ·

Q,

ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 313

and

∂

2

Q

∂S

2

≡ Q

SS

=

−

γ Sy

∗

S

δ

+ H

0

S

(S, t ) −

γ y

∗

δ

−

1/3

γ Y

δ

+

1/3

H

1

S

(S, t )

+

2/3

H

2

S

(S, t ) +H

3

S

(S, t ) + y

∗

S

γ S

δ

−H

4

Y

+· · ·

2

Q

+

H

0

SS

(S, t ) +

1/3

H

1

SS

(S, t ) +

2/3

H

2

SS

(S, t )

+ H

3

SS

(S, t ) −y

∗

SS

H

4

Y

+

2/3

y

∗

2

S

H

4

YY

−2y

∗

S

H

4

Y S

+y

∗

2

s

H

5

YY

+· · ·

Q.

It will be observed that each of the above can be slightly simpliﬁed. We have retained

them in this form to help the reader perform his own calculations.

The advantage of asymptotic analysis will now become clear when we perform the next

step, to substitute these expressions into (2.6) and equate powers of

1/3

.

3.1. The O(1) Equation

To leading order (O(1)) we ﬁnd that

Q

t

=

H

0

t

+

rγ Sy

∗

δ

Q,

Q

S

=

H

0

S

−

γ y

∗

δ

Q,

Q

SS

=

H

0

SS

+

H

0

S

−

γ y

∗

δ

2

Q.

Thus, to leading order equation (2.6) becomes

H

0

t

+

rγ Sy

∗

δ

+µS

H

0

S

−

γ y

∗

δ

+

σ

2

S

2

2

H

0

S

−

γ y

∗

δ

2

+

σ

2

S

2

2

H

0

SS

= 0. (3.5)

3.2. The O(

1/3

) Equation

We can take this procedure to the next order, equating powers of

1/3

. We ﬁnd that

rγ SY

δ

+H

1

t

+µS

−

γ Y

δ

+H

1

S

+σ

2

S

2

−

γ Y

δ

+H

1

S

H

0

S

−

γ y

∗

δ

+

σ

2

S

2

2

H

1

SS

=0.

314 A. E. WHALLEY AND P. WILMOTT

This equation contains a term proportional to Y and one independent of Y. Since all the

other terms in the equation are independent of Y, these terms must separately be zero. From

the ﬁrst of these we ﬁnd that

y

∗

(S, t ) =

δ

γ

H

0

S

+

δ(µ −r)

γ Sσ

2

. (3.6)

Thus, if we can ﬁnd H

0

then we have found the leading order expression for y

∗

.

Equation (3.6) determines the hedging strategy in the absence of transaction costs y

∗

, in

terms of the leading order ‘option value’ H

0

. If we substitute this back into (3.5) we ﬁnd

that H

0

satisﬁes

H

0

t

+

σ

2

S

2

2

H

0

SS

+r SH

0

S

=

(µ −r)

2

2σ

2

. (3.7)

If we write

H

0

(S, t ) =

γ

δ

V

0

(S, t ),

we have

y

∗

(S, t ) = V

0

S

+

δ(µ −r)

γ Sσ

2

(3.8)

as given by Davis et al., and equation (3.7) becomes

V

0

t

+

σ

2

S

2

2

V

0

SS

+r SV

0

S

−r V

0

=

δ(µ −r)

2

2γ σ

2

. (A)

The particular solution of this with zero ﬁnal data is

−

δ(µ −r)

2

(T −t )

2γ σ

2

.

The general solution is thus any solution satisfying the Black–Scholes equation plus this

particular solution.

We then retrace our steps to get from V

0

to V, the option price, using (3.3) and (2.1)

(for both Q

w

and Q

1

). We ﬁnd that the leading order ﬁnal data in the portfolio without the

option liability, (Q

1

), is V

0

(S, T) = 0, whereas in the portfolio with the call option liability,

(Q

w

), it has the usual payoff functional form V

0

(S, T) = −max(S − E, 0). So from the

linearity of (3.2(A)) we see that, to leading order, (or in the absence of any costs) the option

value is simply the Black–Scholes value. Similarly the extra number of shares required

in the portfolio with the additional option liability is, to leading order, the Black–Scholes

delta value.

We now consider the terms independent of Y, which give an equation for H

1

H

1

t

+µSH

1

S

+σ

2

S

2

H

1

S

H

0

S

−

γ y

∗

δ

+

σ

2

S

2

2

H

1

SS

= 0.

ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 315

If we substitute for H

0

S

−

γ y

∗

δ

using (3.8), and set V

1

= δH

1

/γ as above, we ﬁnd that V

1

satisﬁes the Black–Scholes equation. The ﬁnal condition for this equation for both Q

w

and

Q

1

is V

1

(S, t ) = 0. (This is found by expanding the ﬁnal conditions in powers of

1/3

and

considering the terms of O(

1/3

).)

Thus, V

1

is identically zero for all S and t < T, and so the leading order correction to

the Black–Scholes value occurs at the O(

2/3

) level.

3.3. The O(

2/3

) Equation

We nowtake the analysis to higher order to ﬁnd the correction to the Black–Scholes value

due to transaction costs. If we examine the O(

2/3

) terms in (2.6), we ﬁnd that

H

2

t

+r SH

2

S

+

σ

2

S

2

2

H

2

SS

+

σ

2

S

2

2

y

∗

2

S

H

4

YY

+

γ

2

σ

2

S

2

Y

2

2δ

2

= 0.

This is an ordinary differential equation

2

for H

4

which is easily integrated to give

H

4

(S, Y, t ) = −

Y

2

σ

2

S

2

y

∗

2

S

H

2

t

+r SH

2

S

+

σ

2

S

2

2

H

2

SS

−

γ

2

Y

4

12δ

2

y

∗

2

S

+aY +b.

We now have to join this solution in the no-transaction cost region with the solutions

(3.1) and (3.2) in the buy and sell regions respectively.

Let us use the notation Y

+

(S, t ) and −Y

−

(S, t ) to denote the Y-coordinates of the

boundaries of the no-transaction region. These are, of course, unknown and must be

determined as part of the solution by imposing suitable smoothness conditions. As stated

previously, we require Q and its ﬁrst two derivatives with respect to Y to be continuous at

Y = Y

+

and Y = −Y

−

. From (3.1) and (3.2) we can see that continuity of the gradient of

Q at Y = Y

+

and Y = −Y

−

is ensured by

H

4

Y

=

γ S

δ

on Y = Y

+

and

H

4

Y

= −

γ S

δ

on Y = −Y

−

.

Thus,

−

2Y

+

σ

2

S

2

y

∗

2

S

H

2

t

+r SH

2

S

+

σ

2

S

2

2

H

2

SS

−

γ

2

Y

+

3

3δ

2

y

∗

2

S

+a =

γ S

δ

and

2Y

−

σ

2

S

2

y

∗

2

S

H

2

t

+r SH

2

S

+

σ

2

S

2

2

H

2

SS

+

γ

2

Y

−

3

3δ

2

y

∗

2

S

+a = −

γ S

δ

.

2

The inhomogeneous term, proportional to Y

2

, at this order has forced Y dependence in H

4

.

316 A. E. WHALLEY AND P. WILMOTT

The second derivative of Q with respect to Y must also be continuous, that is, zero, at

Y = Y

+

and Y = −Y

−

. If this were not the case then there could be no ﬁnite value for the

option price.

3

Thus,

2

σ

2

S

2

y

∗

2

S

H

2

t

+r SH

2

S

+

σ

2

S

2

2

H

2

SS

= −

γ

2

Y

+,−

2

δ

2

y

∗

2

S

and a = 0. We conclude from this that the no-transaction region is to leading order

symmetric about the Black–Scholes hedging strategy, i.e., Y

−

= Y

+

. Eliminating Y

+

and

Y

−

from these equations we arrive at

H

2

t

+r SH

2

S

+

σ

2

S

2

2

H

2

SS

= −

1

2

3γ

2

S

4

σ

3

y

∗

2

S

2δ

2

2/3

. (3.9)

We also ﬁnd that the edges of the ‘hedging bandwidth,’ Y = Y

+

and Y = −Y

−

, are

given by

Y

+

= Y

−

=

3Sδy

∗

2

S

2γ

1/3

, (3.10)

to leading order.

We cannot stress the importance of this last result enough. As far as implementation of

the optimal hedging is concerned, we need to know the boundaries of the no-transaction

region. These are given by very simple analytic expressions in terms of y

∗

S

, via equation

(3.10), which in turn is simply related to the option’s gamma by equation (3.6). We shall

see this more clearly in the ﬁnal section of this paper.

Equation (3.9) is to be solved subject to the ﬁnal condition

H

2

(S, T) = 0.

By letting

H

2

=

γ

δ

V

2

(S, t )

we can write (3.9) as

V

2

t

+r SV

2

S

+

σ

2

S

2

2

V

2

SS

−r V

2

=−

δ

2γ

3γ

2

S

4

σ

3

2δ

2

2/3

V

0

SS

−

δ(µ −r)

γ S

2

σ

2

4/3

(3.11)

It is nowimportant todistinguishbetweenthe twoproblems for Q

w

, the problemincluding

the option liability, and Q

1

, the problem without the option. The V

2

component of Q

1

3

Recall that the number of the underlying asset held contains a term V

0

S

, as in Black–Scholes, to leading order.

The inﬁnite number of trades in a ﬁnite time required at the boundary of the no-transaction region would lead to

an inﬁnite cost unless the gamma of the option is zero at the boundary.

ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 317

satisﬁes (3.11) with V

0

SS

= 0, i.e.,

V

2

t

+r SV

2

S

+

σ

2

S

2

2

V

2

SS

−r V

2

= −

1

2

3

2σ

2/3

δ(µ −r)

4/3

γ

.

This has solution with zero ﬁnal data

V

2

=

1

2

3

2σ

2/3

δ(µ −r)

4/3

(T −t )

γ

.

Using W(S, t ) to denote the Black–Scholes option value we see that the V

2

component

of Q

w

satisﬁes (3.11) with V

0

SS

being the Black–Scholes value for the gamma, i.e., W

SS

.

Thus we see that the option value correct to O(

2/3

) is simply

V(S, t ) = W(S, t ) +

2/3

V

2

(S, t ) −

1

2

3

2σ

2/3

δ(µ −r)

4/3

(T −t )

γ

+· · · ,

where V

2

satisﬁes (3.11) with V

0

SS

= W

SS

.

3.4. The O() Equation

It is remarkable that the algebraic complexity of the problen is still manageable at the

O() level. We can thus take the asymptotic analysis even further.

The O() terms in expression (2.6) give

H

3

t

−y

∗

t

H

4

Y

+µS

H

3

S

− y

∗

S

H

4

Y

+

σ

2

S

2

2

H

3

SS

− y

∗

SS

H

4

Y

−2y

∗

S

H

4

Y S

(3.12)

+ y

∗

2

S

H

5

YY

+2

H

0

S

−

γ y

∗

δ

H

3

S

− y

∗

S

H

4

Y

−

2γ Y

δ

H

2

S

= 0.

This may be interpreted ﬁrst as an ordinary differential equation for H

5

and then, given

sufﬁcient boundary conditions, as a partial differential equation for H

3

(just as in the H

2

,

H

4

problem of Section 3.3). To determine the correct boundary conditions, recall that we

must have continuity of ﬁrst and second derivatives with respect to Y at all orders of .

Thus

H

4

Y

+

1/3

H

5

Y

= ±

γ S

δ

(3.13)

on the top and bottom free boundaries. By going to higher order we must also expand the

position of the free boundaries as power series in

1/3

. Transferring the boundary condition

318 A. E. WHALLEY AND P. WILMOTT

(3.13) onto the known leading order boundaries y = Y

+

and y = −Y

−

, we ﬁnd that

H

5

Y

= 0 on y = Y

+

and y = −Y

−

,

since H

4

YY

= 0 on y = Y

+

and y = −Y

−

.

Now integrate (3.12) from y = −Y

−

to y = Y

+

. We ﬁnd that

H

3

t

+r SH

3

S

+

σ

2

S

2

2

H

3

SS

= 0 (3.14)

(since

Y

+

−Y

−

H

4

Y

dY = 0). With H

3

= γ V

3

/δ we can now see that V

3

satisﬁes the Black–

Scholes equation.

The ﬁnal data for this equation is, for both the 1 and the w problems,

H

3

(S, T) =

(µ −r)

σ

2

.

This is found by expanding (2.2) and (2.3) in powers of

1/3

. The solution of (3.14) with

this ﬁnal data is simply

H

3

(S, t ) =

(µ −r)

σ

2

.

The only remaining step in calculating the option value to O() is to apply continuity

between the no-transaction region and the buy region. We have

H

−

= H

0

+

2/3

H

2

+

H

3

+

γ S

δ

y

∗

.

Finally, since the option value depends on Q(S, 0, t ), we need the result

Q(S, 0, t ) = exp(H

−

).

From (2.1) we now have

V(S, t )=W(S, t )+

2/3

V

2

(S, t )−

1

2

3

2σ

2/3

δ(µ −r)

4/3

(T −t )

γ

+SW

S

+O(

4/3

),

where V

2

satisﬁes (3.11) with V

0

SS

= W

SS

. Observe that the O() correction to our earlier

result is simply the cost of changing the number of shares in the portfolio in order to set

up the initial hedge! Recall that it is assumed that the option obligation will be held until

maturity, and that the ﬁnal condition incorporates any transaction costs payable at maturity

in order to unwind the hedge.

ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 319

FIGURE 4.1. The hedge ratio and no-transaction band as functions of S without the option

liability. See the text for details of parameters.

4. RESULTS AND CONCLUSIONS

In this section we give the results of our asymptotic limit of the Davis et al. model and make

comparisons with their numerical results. To be speciﬁc we have concentrated on examples

given in Davis et al.

First, we consider a European call option with exercise price E = 0.5 and time to expiry

0.3. Other parameters are r = 0.07, σ = 0.2, µ = 0.1, and γ = 1.0. The level of

transaction costs is such that = 0.002.

In Figure 4.1 we plot the solution for y

∗

and the hedging boundaries against S for the

ﬁrst problem (denoted by subscript 1), which does not have the option liability at expiry.

The solution in the absence of costs, y

∗

, is the middle curve. The outer, bold curves are the

boundaries of the no-transaction region when there are nonzero transaction costs as detailed

above. Recalling our expressions for y

∗

, equation (3.6), and Y

+

and Y

−

, equation (3.10),

these three curves are given by

y = y

∗

(S, t ) =

δ(µ −r)

γ Sσ

2

and

y =

δ(µ −r)

γ Sσ

2

±

1/3

3Sδy

∗

2

S

2γ

1/3

=

δ(µ −r)

γ Sσ

2

±

1/3

3δ

3

(µ −r)

2

2γ

3

σ

4

S

3

1/3

.

320 A. E. WHALLEY AND P. WILMOTT

FIGURE 4.2. The hedge ratio and no-transaction band as functions of S for the problemwith

the option liability. See the text for details of parameters.

In Figure 4.2 we plot the equivalent solutions for the second problem (denoted by the

subscript w), which includes the option liability at expiry. Again y

∗

, the solution in the

absence of transaction costs, is the middle curve and two bold curves are the boundaries of

the no-transaction region. These three curves are given by

y = y

∗

(S, t ) = W

S

+

δ(µ −r)

γ Sσ

2

and

y = W

S

+

δ(µ −r)

γ Sσ

2

±

1/3

3Sδy

∗

2

S

2γ

1/3

= W

S

+

δ(µ −r)

γ Sσ

2

±

1/3

3Sδ

2γ

W

SS

−

δ(µ −r)

γ S

2

σ

2

2

1/3

where W is the Black–Scholes call value.

This plot is of particular interest. Because y

∗

has turning points, the width of the no-

transaction region (which is proportional to (y

∗

S

)

2/3

) goes to zero. This gives the ‘string of

sausages’ shape shown in Figure 4.2. This result has an obvious ﬁnancial interpretation.

At the two turning points of y

∗

, a relatively large change in the share price can be tolerated

before rehedging is necessary. In stochastic terms, to leading order, we have

dy

∗

= y

∗

S

dS +· · · .

ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 321

FIGURE 4.3. The difference between the asymptotic limit of the Davis et al. model and the

Black–Scholes value for a European call. The bold curve is the sumof the other two curves.

See the text for details of parameters.

Away from turning points dy

∗

is of the same order as dS. However, at the two turning

points dy

∗

becomes deterministic and of higher order. Thus it is possible to impose tighter

bounds on the no-transaction region and this is exactly what is seen.

In deriving these plots we have not had to solve any differential equation since the

functions y

∗

and Y

+

depend only on W, the Black–Scholes call value.

We nowmove on to another example. The parameters in this case are = 0.002, γ = 1.0,

σ = 0.05, r = 0.085, and µ = 0.1. We consider a European call with exercise price 20

and with up to three years until expiry.

The plot in Figure 4.3 shows the difference between the asymptotic limit of the Davis

et al. model and the Black–Scholes call option value. This is the bold curve. It has two

components, the O(

2/3

) part and the O() part, and these two curves are also shown in

the ﬁgure. The bold curve is the sum of the other two curves. Note that the O(

2/3

) and

the O() curves are similar in magnitude. This is because they differ by a factor of order

O(

1/3

) which for = 0.002 is 0.13 and not very small.

This plot (and Figure 4.4) has required the solution of (3.11). The solution shown

in Figure 4.3 was computed by a simple explicit ﬁnite-difference scheme and thus took

approximately the same time to run as the binomial solution of an American option.

In Figure 4.4 we plot the time dependence of the difference between the asymptotic

limit of the Davis et al. model and the Black–Scholes value, for the same parameters as in

Figure 4.3 with S = 19. This is the bold curve and is the sum of the lower two curves.

Againthese O(

2/3

) and O() curves are similar inmagnitude. Nevertheless this asymptotic

solution shows very good agreement with the numerical results of Davis et al., also plotted.

To ﬁnish this paper, let us recall the model of Leland (1985) and of Hoggard et al. (1994).

In that model it is assumed that a delta-hedged portfolio is rehedged every ﬁxed time period

δt . The option is then valued so as to give the hedged portfolio the same expected return as

that from a bank. With the same cost structure as above it is readily found that for a short

322 A. E. WHALLEY AND P. WILMOTT

FIGURE 4.4. The difference between the asymptotic limit of the Davis et al. model and the

Black–Scholes value for a European call as a function of time to expiry. The unlabeled

bold curve is the sum of the lower two curves. Numerical results taken from Davis et al.

are also shown.

position

V

t

+r SV

S

+

σ

2

S

2

2

V

SS

−r V = −

2

πδt

σ S

2

|V

SS

| .

By writing V(S, t ) = W(S, t ) +V

2

(S, t ) +· · · we have

V

2

t

+r SV

2

S

+

σ

2

S

2

2

V

2

SS

−r V

2

= −

2

πδt

σ S

2

|W

SS

| , (3.15)

with V

2

(S, T) = 0.

Now recall the model of Whalley and Wilmott (1993). In that model the investor delta

hedges with rehedging determined by ‘market movements.’ If the difference between

the delta and the number of assets actually held becomes greater than d(S, t )/S then the

portfolio is rehedged to the delta value giving the portfolio the minimum variance. The

function d(S, t ) which speciﬁes the hedging bandwidth must be prescribed by the investor.

The option value is again determined by assuming that the expected return is equal to the

risk-free rate. With V(S, t ) = W(S, t ) + V

2

(S, t ) + · · · it is found that this time the

correction term for a short position satisﬁes

V

2

t

+r SV

2

S

+

σ

2

S

2

2

V

2

SS

−r V

2

= −

σ

2

S

4

d

1/2

W

2

SS

, (3.16)

with V

2

(S, T) = 0. This models a strategy commonly used in practice.

Now we can see the similarities between the three different models. All of them give

the Black–Scholes value to leading order with a smaller order correction. This correction

differs between models, but in all cases satisﬁes an ‘inhomogeneous Black–Scholes-type

ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 323

equation,’ where the extra term resulting from the transaction costs depends on some power

of the Black–Scholes option gamma (W

SS

).

In Whalley and Wilmott (1993) many issues arising from such equations are discussed.

Brieﬂy, these include the following.

1. Nonlinearity. Since the right-hand side of the V

2

equation is in each case a non-

linear function of the Black–Scholes value of gamma, W

SS

, there will inevitably

be different values for short and long positions. Also portfolios of options must be

treated as a whole and not as the sum of individually valued components.

2. Negative option prices. With the more general costs structure discussed in Hoggard

et al. and Whalley and Wilmott (not simply bid–offer spread) it is possible to arrive

at negative option prices. (To see this, consider the commission component of costs.

If a ﬁxed amount is paid at each rehedge, then for small asset values the call option

can have a negative value.) This suggests modifying hedging strategies to allow

the possibility of not rehedging if to rehedge would make the option value negative.

This introduces a free boundary below which (for a call) the option should not be

rehedged. However, it is unlikely that the simple bid–offer spread considered here

would lead to negative option prices.

3. American options. As also mentioned in Davis et al. it is the owner of the American

option who controls its exercise. It is difﬁcult to optimally value an American option

unless the owner’s hedging and exercise strategy is known. This entails at least

knowing all of his estimates of the parameters.

From the point of view of the numerical solution of these equations we can say that the

inhomogeneous equations will not take signiﬁcantly longer to solve by ﬁnite-difference

methods than the basic inhomogeneous Black–Scholes equation. Thus, by performing this

simple asymptotic analysis of the Davis et al. model, we have made its use a practical

possibility.

REFERENCES

ATKINSON, C. ANDP. WILMOTT (1995): “Portfolio management with transaction costs: An asymptotic

analysis.” Math. Finance, 5, 357–367.

BLACK, F. AND M. SCHOLES (1973): “The pricing of options and corporate liabilities.” J. Political

Economy, 81, 637–54.

BOYLE, P. P. AND T. VORST (1992): “Option replication in discrete time with transaction costs.”

J. Finance, 47, 271.

DAVIS, M. H. A., V. G. PANAS, AND T. ZARIPHOPOULOU (1993): “European option pricing with

transaction costs.” SIAM J. Control Optim., 31, 470–493.

FLEMING, W. H., S. D. GROSSMAN, J.-L. VILA, AND T. ZARIPHOPOULOU (1990): “Optimal portfolio

rebalancing with transaction costs.” Working paper, Division of Applied Mathematics, Brown

University.

HINCH, E. J. (1991): Perturbation Methods. New York: Cambridge University Press.

HODGES, S. D. AND A. NEUBERGER (1989): “Optimal replication of contingent claims under trans-

action costs.” Rev. Futures Markets, 8, 222–239.

HOGGARD, T., A. E. WHALLEY, AND P. WILMOTT (1994): “Hedging option portfolios in the presence

of transaction costs.” Adv. Futures Opt. Res., 7, 21.

LELAND, H. E. (1985): “Option pricing and replication with transaction costs.” J. Finance, 40, 1283–

301.

324 A. E. WHALLEY AND P. WILMOTT

MOHAMED, B. (1994): “Simulations of transaction costs and optimal rehedging.” Appl. Math. Fin.,

1, 49–63.

MORTON, A. AND S. PLISKA (1995): “Optimal portfolio management with ﬁxed transaction costs.”

Math. Finance, 5, 337–356.

SHREVE, S. E. AND H. M. SONER (1994): “Optimal nvestment and consumption with transaction

costs.” Ann. Applied Prob., 4, 680–692.

WHALLEY, A. E. AND P. WILMOTT (1993). “A hedging strategy and option valuation model with

transaction costs.” OCIAM Working paper, Mathematical Institute, Oxford.

we shall ﬁnd an equation similar to the Black–Scholes equation but with additional small terms that allow for the cost of rehedging and that are nonlinear in the option’s gamma. There is great practitioner resistance to the idea of utility theory. For example. For this reason. to our knowledge. WILMOTT The models are slow to compute since they usually result in three. As yet. amounting to the payoff function for the option in question. t) is the value of an option. and found to be the best strategy he tested. and Zariphopoulou paper. . THE MODEL OF DAVIS. This results in an inhomogeneous diffusion equation for the price of an option. t is time. We shall continue to use W to denote the Black–Scholes value of a European option. assumed deterministic. In Section 3 we consider the asymptotic limit of small transaction costs. and Zariphopoulou (1993) model. In this paper we perform a simple asymptotic analysis of the Davis. Panas. This equation must be solved for t < T and 0 ≤ S < ∞. This is the problem to be solved in the absence of costs. σ the volatility of the underlying. Perturbation analysis is a very powerful tool of applied mathematics. In Section 4 we compare the model with others and draw conclusions. the interested reader should read that paper carefully in conjunction with this. The asymptotic formulas for the hedging strategy we present here have been tested empirically by Mohamed (1994). AND ZARIPHOPOULOU In the model of Davis. r the interest rate. see Atkinson and Wilmott (1993). T ) = max(S − E. On t = T we must impose a ﬁnal condition. For comparison. WHALLEY AND P.or four-dimensional free boundary problems. E. for an asymptotic analysis of the Morton and Pliska (1995) portfolio management problem with transaction costs. we are initially considering the valuation of a short European call option. for a call option with strike price E we have W (S. We thus bring together the competing philosophies behind modeling transaction costs. In Section 2 we very brieﬂy describe the model of Davis. 2 Here S is the underlying asset price. rarely been used in ﬁnance.1) Wt + r SW S + σ 2 S2 W SS − r W = 0. and Zariphopoulou (1993). When there are no costs this results in the Black–Scholes value for the option (Black and Scholes 1973). the technique has. because it reveals the salient features of the problem while remaining a good approximation to the full but more complicated model. we shall at times walk the reader very slowly through the calculations. and Zariphopoulou (1993) the writing price of a European option is deﬁned in terms of a utility maximization problem. in the limit of small transaction costs. and W (S. Panas. 0). 2. We show how. In the presence of costs. It is used to great effect in areas such as ﬂuid mechanics (Hinch 1991). the option price (to the writer) is obtained by a comparison of the maximum utilities of trading with and without the obligation of fulﬁlling the option contract at expiry. Panas. In common with the Davis. Recall that in the absence of transaction costs the Black–Scholes equation for the value of an option is (1.308 A. PANAS. their three-dimensional free boundary problem reduces to a much simpler two-dimensional inhomogeneous diffusion equation of the form found in the local-in-time models. Simply put. Panas.

1 or more generally commissions and costs that are proportional to the value of the assets traded. Finally. ∂ Q/∂ S. + µS + ∂y δ ∂y δ ∂t ∂S 2 ∂ S2 = 0. For options with delivery of the asset on exercise the analysis below remains the same. t) is given by V (S. When the utility function takes the special form U(x) = 1 − exp(−γ x) (so that γ is the index of risk aversion) Davis et al. t) = e−r (T −t) .2) and (2. t) = δ(T. y. to fully pose the problem we must specify that for t < T . .3) where c(S. y. Q w (S. t) and Q w (S. t) both satisfy the following equation γ (1 + )S Q ∂Q γ (1 − )S Q ∂ Q ∂Q σ 2 S2 ∂ 2 Q ∂Q + . 1 Davis et al. The independent variable y measures the number of shares held in the optimally hedged portfolio. ﬁnd that the option price V (S.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 309 The asset price S is assumed to follow the random walk d S = µS dt + σ S d X.1) where T is the expiry date. 0. Q. and ∂ 2 Q/∂ S 2 must all be continuous. 0. Note we are assuming here that the option is settled in cash. y. The two functions Q 1 and Q w must satisfy certain ﬁnal conditions. where µ and σ are constant and X is a Brownian motion. min Here measures the transaction costs: A trade of N shares will result in a loss of N S. consider the slightly more general case in which there are different levels of cost for buying and selling. t) (2. − − . y)) So the ﬁnal condition for the second problem (with subscript w) is equal to that of the ﬁrst problem (with subscript 1) modiﬁed by the effects of the potential liability at expiry of the European call (after transaction costs). This cost structure represents bid–offer spread. y) + E − S)) S≤E S>E Q 1 (S. t) log γ Q w (S. y)) exp(−γ (c(S. T ) = exp(−γ c(S. and Q 1 (S. the ﬁnal conditions merely alter. δ(T. y. for example. Q 1 (S. t) . T ) = exp(−γ c(S. analogous to the payoff proﬁle of the option. for a call option (2. y) = (1 + )y S (1 − )y S y<0 y ≥ 0.

4) In the sell region we have (2.5) γ (1 − )S Q ∂Q + = 0. E. We shall ﬁnd simple analytical expressions for all three of these curves.1 is the curve along which the investor must move in the absence of transaction costs. Both y ∗ and the position of the upper and lower boundaries are to be found. this curve is denoted by y = y ∗ (S. ∂y δ . how the (S.310 A. y) space divides into three regions. The middle line in Figure 2. ∂y δ (2. It is explained by Davis et al. while inside this region he does not transact. t). shown schematically in Figure 2.1. WHALLEY AND P. if he hits the bottom boundary he must buy shares. A schematic diagram of (S. y) space bounded by the two outer curves.1. In the buy region we have γ (1 + )S Q ∂Q + = 0. y) space showing the buy. sell. This is a free boundary problem. WILMOTT FIGURE 2. Should a movement of the asset price take the writer to the edge of this no-transaction region he must trade so as to just stay inside. If he hits the top boundary he must sell shares. and no-transaction regions. The writer of the option must always maintain his portfolio in the region of the (S.

t) + H3 (S. we have chosen to expand in powers of 1/3 .2) Q = exp − This contains another arbitrary function H + .1) Q = exp − γS y γ Sy − + H − (S. ∂ Q/∂ S. This is not an arbitrary choice. y. t) in the buy region is found to be (3. rather we shall ﬁnd the asymptotic solution valid for small .5) to get γ Sy γS y + + H + (S. Y. t) + 5/3 H5 (S. + µS + ∂t ∂S 2 ∂ S2 (2. t.2) are the exact. and ∂ 2 Q/∂ S 2 must all be continuous. The solution in the no-transaction region is much harder to ﬁnd. ) δ δ where H − is.4): in this equation S and t are effectively parameters. 3. an arbitrary function of S and t that comes from solving the ordinary differential equation (2. δ δ (3. ASYMPTOTIC ANALYSIS FOR SMALL LEVELS OF TRANSACTION COSTS Equation (2. 1994. Indeed.1) Q.6) This is the free boundary problem we shall shortly solve asymptotically. general solutions of (2. t. Y. ) . First.3) Q = exp − SY + δ 1/3 H1 (S.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 311 In the no-transaction region we have ∂Q σ 2 S2 ∂ 2 Q ∂Q = 0. When we come to apply the ﬁnal data we will distinguish between Q 1 and Q w as necessary. t) − δ 4/3 1/3 γ (3. The solution for Q(S. Because the two problems for Q 1 and Q w are identical except for the ﬁnal data. and notes that Fleming. t) + 2/3 H2 (S. we need only perform the analysis for one of them. as yet. t) + · · · . we shall see how such a choice is the natural one.1) and (3. t) + H4 (S. The ﬁrst stage in determining this solution is to expand Q in an asymptotic series in powers of . In the sell region we can similarly solve (2. (Shreve and Soner. Vila. The two expressions (3. As we perform our analysis.4) is very easy to solve explicitly. have results that suggest a similar asymptotic scale for the width of the no-transaction interval for an optimal investment and consumption model with transaction costs under a different utility function. There are two very important things to note about this expression. across the two free boundaries (the outer curves in Figure 2. We write the solution in the no-transaction region as γ Sy ∗ + H0 (S. we shall not ﬁnd the general solution.4) and (2. Grossman. and Zariphopoulou (1990) have also obtained this .6). As mentioned above.

∂Y ∂ ∂ → − ∂S ∂S ∂ ∂ → − ∂t ∂t Thus we readily ﬁnd from (3. in performing this analysis. Y turns out to be a more natural variable to use than y. t) + 2/3 H2S (S. y ∗ . that the choice of a series expansion in powers of 1/3 is inevitable.1). We must now ﬁnd the functions Hi such that this equation and all relevant boundary and smoothness conditions are satisﬁed.3).2) and continuity of slope at the boundary of the no-transaction region. The factor of 1/3 represents the scale of the asymptotic width of the no-transaction region for this type of transaction costs (proportional to value traded). As yet (3. t) + H3t (S. t) − − ∂S δ δ δ + + 1/3 H1S (S. WHALLEY AND P. t) + yS . ∗ γ SyS γ y∗ ∂Q ≡ QS = − + H0S (S. The former is forced by the leading terms in (3. t) + yt∗ + · · · Q. The reason for the latter is similar and the details will become apparent. we have translated the y coordinate according to (3. WILMOTT scale. ∂Y γ Syt∗ r γ Sy ∗ ∂Q ≡ Qt = − + H0t (S. t) γS − H4Y δ 1/3 γ Y 4/3 H4t (S. Y. E. in (3.1) and (3. t) + + ∂t δ δ + + 1/3 1/3 r γ SY δ H1t (S. t) + 2/3 H2t (S.3) and (3. It is a measure of the difference between the number of shares actually held in the portfolio and the ideal number we would hold in the absence of transction costs.4) that −1/3 ∗ yS ∂ .) Second.6) are with respect to t and S keeping y ﬁxed. We shall ﬁnd an explicit expression for y ∗ as a function of S and t. there is Y dependence at O( 1/3 ) and O( 4/3 ). 4/3 ∗ H4S (S. We shall see.4) y = y ∗ (S. Observe how. Thus Y is a rescaled variable (see Figure 2. t) γS − H4Y δ + · · · Q.3) does not satisfy the equation in the no-transaction region. Y. then ∂ → ∂y −1/3 ∂ . It is such continuity requirements that actually force on us the special choice of 1/3 . Since the derivatives in (2. t) + 1/3 Y. t) + H3S (S.312 A. ∂Y −1/3 ∗ yt ∂ .

2.6) and equate powers of 1/3 . equating powers of γY γY r γ SY + H1t +µS − + H1S +σ 2 S 2 − + H1S δ δ δ . QS = H0S − γ y∗ δ Q. to substitute these expressions into (2. t) − − ∂ S2 δ δ 1/3 γ Y δ + 1/3 H1S (S. t) 2 + 2/3 ∗ H2S (S.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 313 and ∗ γ SyS γ y∗ ∂2 Q ≡ Q SS = − + H0S (S. 2 3. t) + H1SS (S. δ 2 . We ﬁnd that H0S − γ y∗ σ 2 S2 + H1SS = 0. The O(1) Equation To leading order (O(1)) we ﬁnd that r γ Sy ∗ δ Qt = H0t + Q.5) H0t + + σ 2 S2 2 H0S − γ y∗ δ 2 + σ 2 S2 H0SS = 0. We have retained them in this form to help the reader perform his own calculations. The advantage of asymptotic analysis will now become clear when we perform the next step. to leading order equation (2. t) ∗ ∗ − 2 yS H4Y S + ys H5Y Y + · · · Q. Thus. t) + yS 1/3 γS − H4Y δ + ··· Q + H0SS (S. Q SS = H0SS + H0S − γ y∗ δ 2 Q. t) + H3S (S. t) + 2/3 H2SS (S.6) becomes r γ Sy ∗ γ y∗ + µS H0S − δ δ 1/3 (3.1. 3. 2 ∗ + H3SS (S. The O( ) Equation 1/3 We can take this procedure to the next order. t) − ySS H4Y + 2/3 ∗2 yS H4Y Y It will be observed that each of the above can be slightly simpliﬁed.

8) y ∗ (S. is V0 (S. in terms of the leading order ‘option value’ H0 . to leading order. T ) = −max(S − E. t) = we have (3. WHALLEY AND P. H0 + γ S γ Sσ 2 Thus. 0). (Q 1 ). these terms must separately be zero. WILMOTT This equation contains a term proportional to Y and one independent of Y .6) determines the hedging strategy in the absence of transaction costs y ∗ . t).7) becomes V0t + σ 2 S2 δ(µ − r )2 V0SS + r SV0S − r V0 = . We then retrace our steps to get from V0 to V . Similarly the extra number of shares required in the portfolio with the additional option liability is.3) and (2. (Q w ). 2 . H0SS + r S H0S = 2 2σ 2 as given by Davis et al. So from the linearity of (3. δ H0t + σ 2 S2 (µ − r )2 .2(A)) we see that. and equation (3. 2γ σ 2 The general solution is thus any solution satisfying the Black–Scholes equation plus this particular solution. If we substitute this back into (3. Equation (3. the Black–Scholes delta value.314 A. it has the usual payoff functional form V0 (S.6) y ∗ (S.. 2 2γ σ 2 (A) The particular solution of this with zero ﬁnal data is − δ(µ − r )2 (T − t) . to leading order.7) If we write H0 (S. t) = V0S + δ(µ − r ) γ Sσ 2 γ V0 (S. the option price. We now consider the terms independent of Y . which give an equation for H1 H1t + µS H1S + σ 2 S 2 H1S H0S − γ y∗ δ + σ 2 S2 H1SS = 0.1) (for both Q w and Q 1 ). if we can ﬁnd H0 then we have found the leading order expression for y ∗ . Since all the other terms in the equation are independent of Y . t) = δ δ(µ − r ) . From the ﬁrst of these we ﬁnd that (3. (or in the absence of any costs) the option value is simply the Black–Scholes value. E.5) we ﬁnd that H0 satisﬁes (3. We ﬁnd that the leading order ﬁnal data in the portfolio without the option liability. whereas in the portfolio with the call option liability. T ) = 0. using (3.

H2SS + yS H4Y Y + 2 2 2δ 2 This is an ordinary differential equation2 for H4 which is easily integrated to give H4 (S. If we examine the O( 2/3 ) terms in (2. we ﬁnd that V1 satisﬁes the Black–Scholes equation.6).1) and (3.2) we can see that continuity of the gradient of Q at Y = Y + and Y = −Y − is ensured by H4Y = and H4Y = − Thus.2) in the buy and sell regions respectively.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL ∗ 315 y If we substitute for H0S − γ δ using (3. and set V1 = δ H1 /γ as above. (This is found by expanding the ﬁnal conditions in powers of 1/3 and considering the terms of O( 1/3 ). of course. unknown and must be determined as part of the solution by imposing suitable smoothness conditions. t) and −Y − (S. proportional to Y 2 . The O( 2/3 ) Equation We now take the analysis to higher order to ﬁnd the correction to the Black–Scholes value due to transaction costs. V1 is identically zero for all S and t < T . These are. 3.) Thus.3. and so the leading order correction to the Black–Scholes value occurs at the O( 2/3 ) level. t) to denote the Y -coordinates of the boundaries of the no-transaction region. Y. As stated previously.1) and (3.8). t) = 0. The ﬁnal condition for this equation for both Q w and Q 1 is V1 (S. at this order has forced Y dependence in H4 . δ inhomogeneous term. . We now have to join this solution in the no-transaction cost region with the solutions (3. 2Y + σ 2 S2 y S ∗2 H2t + r S H2S + σ 2 S2 H2SS 2 − γ 2Y + 3δ 2 y S 3 ∗2 +a = γS δ H2t + r S H2S + σ 2 S2 H2SS 2 + γ 2Y − 3 ∗2 3δ 2 yS +a =− γS . − and 2Y − ∗2 σ 2 S 2 yS 2 The γS δ on Y = Y + γS δ on Y = −Y − . we ﬁnd that H2t + r S H2S + σ 2 S2 σ 2 S 2 ∗2 γ 2σ 2 S2Y 2 = 0. we require Q and its ﬁrst two derivatives with respect to Y to be continuous at Y = Y + and Y = −Y − . t) = − Y2 σ 2 S 2 yS ∗2 H2t + r S H2S + σ 2 S2 H2SS 2 − γ 2Y 4 ∗ 12δ 2 yS 2 + aY + b. From (3. Let us use the notation Y + (S.

2 ∗ σ 2 S 2 yS 2 σ 2 S2 H2SS H2t + r S H2S + 2 =− γ 2 Y +. i. We conclude from this that the no-transaction region is to leading order symmetric about the Black–Scholes hedging strategy. are given by (3. Eliminating Y + and Y − from these equations we arrive at σ 2 S2 1 H2SS = − 2 2 ∗ 3γ 2 S 4 σ 3 yS 2 2δ 2 2/3 (3. Equation (3.− ∗ δ 2 yS 2 2 and a = 0.e. We also ﬁnd that the edges of the ‘hedging bandwidth. As far as implementation of the optimal hedging is concerned. the problem including the option liability. the problem without the option. at Y = Y + and Y = −Y − . that is.3 Thus. .9) as σ 2 S2 δ V2SS −r V2 = − 2 2γ 3γ 2 S 4 σ 3 2δ 2 2/3 γ V2 (S. zero. via equation (3. as in Black–Scholes. and Q 1 .11) V2t +r SV2S + V0SS − δ(µ − r ) γ S2σ 2 4/3 It is now important to distinguish between the two problems for Q w .9) is to be solved subject to the ﬁnal condition H2 (S. we need to know the boundaries of the no-transaction ∗ region.6). If this were not the case then there could be no ﬁnite value for the option price. We shall see this more clearly in the ﬁnal section of this paper.9) H2t + r S H2S + . WILMOTT The second derivative of Q with respect to Y must also be continuous. to leading order. T ) = 0. WHALLEY AND P. Y − = Y + . which in turn is simply related to the option’s gamma by equation (3.’ Y = Y + and Y = −Y − . The V2 component of Q 1 3 Recall that the number of the underlying asset held contains a term V . t) δ (3. These are given by very simple analytic expressions in terms of yS .316 A.10) Y+ = Y− = ∗ 3SδyS 2γ 2 1/3 .10). 0S The inﬁnite number of trades in a ﬁnite time required at the boundary of the no-transaction region would lead to an inﬁnite cost unless the gamma of the option is zero at the boundary.. to leading order. We cannot stress the importance of this last result enough. E. By letting H2 = we can write (3.

σ 2 S2 1 V2SS − r V2 = − 2 2 3 2σ 2/3 V2t + r SV2S + δ(µ − r )4/3 .11) with V0SS = 0. H4 problem of Section 3.12) ∗ H3t − yt∗ H4Y + µS H3S − yS H4Y + ∗ + yS H5Y Y + 2 H0S − 2 γ y∗ δ ∗ H3S − yS H4Y − This may be interpreted ﬁrst as an ordinary differential equation for H5 and then.6) give σ 2 S2 ∗ ∗ H3SS − ySS H4Y − 2yS H4Y S 2 2γ Y H2S δ = 0. To determine the correct boundary conditions. The O( ) terms in expression (2.. t) to denote the Black–Scholes option value we see that the V2 component of Q w satisﬁes (3.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 317 satisﬁes (3. t) = W (S.4. recall that we must have continuity of ﬁrst and second derivatives with respect to Y at all orders of . i. Thus (3. W SS . By going to higher order we must also expand the position of the free boundaries as power series in 1/3 . i.3).13) H4Y + 1/3 H5Y = ± γS δ on the top and bottom free boundaries. The O( ) Equation It is remarkable that the algebraic complexity of the problen is still manageable at the O( ) level. We can thus take the asymptotic analysis even further. as a partial differential equation for H3 (just as in the H2 . t) + 2/3 V2 (S.e.11) with V0SS being the Black–Scholes value for the gamma.11) with V0SS = W SS . 3.. γ This has solution with zero ﬁnal data 1 2 3 2σ 2/3 V2 = δ(µ − r )4/3 (T − t) . γ Using W (S. where V2 satisﬁes (3. given sufﬁcient boundary conditions. t) − 1 2 3 2σ δ(µ − r )4/3 (T − t) γ + ···.e. (3. Thus we see that the option value correct to O( 2/3 ) is simply 2/3 V (S. Transferring the boundary condition .

t) = W (S. δ Finally.13) onto the known leading order boundaries y = Y + and y = −Y − . t). . for both the 1 and the w problems. WHALLEY AND P. With H3 = γ V3 /δ we can now see that V3 satisﬁes the Black– Scholes equation. WILMOTT (3. since the option value depends on Q(S. where V2 satisﬁes (3. t)+ 2/3 V2 (S. t) = exp(H − ). we ﬁnd that H5Y = 0 on y = Y+ and y = −Y − . T ) = (µ − r ) . E.1) we now have 1 2 3 2σ 2/3 V (S. We have H − = H0 + 2/3 H2 + H3 + γS ∗ y . t)− δ(µ − r )4/3 (T − t) + SW S + O( γ 4/3 ). We ﬁnd that H3t + r S H3S + Y+ (3. we need the result Q(S.11) with V0SS = W SS .14) with The only remaining step in calculating the option value to O( ) is to apply continuity between the no-transaction region and the buy region.3) in powers of this ﬁnal data is simply H3 (S. Now integrate (3. σ2 . t) = (µ − r ) . Observe that the O( ) correction to our earlier result is simply the cost of changing the number of shares in the portfolio in order to set up the initial hedge! Recall that it is assumed that the option obligation will be held until maturity. The solution of (3.12) from y = −Y − to y = Y + . 0.2) and (2.14) σ 2 S2 H3SS = 0 2 (since −Y − H4Y dY = 0). σ2 1/3 This is found by expanding (2. The ﬁnal data for this equation is. From (2.318 A. 0. since H4Y Y = 0 on y = Y + and y = −Y − . and that the ﬁnal condition incorporates any transaction costs payable at maturity in order to unwind the hedge. H3 (S.

The solution in the absence of costs. See the text for details of parameters. these three curves are given by δ(µ − r ) γ Sσ 2 y = y ∗ (S. equation (3. and γ = 1. Other parameters are r = 0. The hedge ratio and no-transaction band as functions of S without the option liability. model and make comparisons with their numerical results. bold curves are the boundaries of the no-transaction region when there are nonzero transaction costs as detailed above.1. Recalling our expressions for y ∗ .6). is the middle curve. t) = and δ(µ − r ) y = ± γ Sσ 2 δ(µ − r ) = ± γ Sσ 2 ∗ 3SδyS 2γ 2 1/3 1/3 1/3 3δ 3 (µ − r )2 2γ 3 σ 4 S 3 1/3 . To be speciﬁc we have concentrated on examples given in Davis et al.07.2. RESULTS AND CONCLUSIONS In this section we give the results of our asymptotic limit of the Davis et al. equation (3. In Figure 4. The outer. µ = 0.3. The level of transaction costs is such that = 0.5 and time to expiry 0. we consider a European call option with exercise price E = 0. 4. y ∗ . and Y + and Y − .0.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 319 FIGURE 4. . which does not have the option liability at expiry.10).002. First.1. σ = 0.1 we plot the solution for y ∗ and the hedging boundaries against S for the ﬁrst problem (denoted by subscript 1).

320 A.2 we plot the equivalent solutions for the second problem (denoted by the subscript w). a relatively large change in the share price can be tolerated before rehedging is necessary.2. WHALLEY AND P. . In stochastic terms. E. In Figure 4. Again y ∗ . The hedge ratio and no-transaction band as functions of S for the problem with the option liability. At the two turning points of y ∗ .2. the width of the no∗ transaction region (which is proportional to (yS )2/3 ) goes to zero. is the middle curve and two bold curves are the boundaries of the no-transaction region. WILMOTT FIGURE 4. to leading order. which includes the option liability at expiry. This plot is of particular interest. This result has an obvious ﬁnancial interpretation. we have ∗ dy ∗ = yS d S + · · · . Because y ∗ has turning points. the solution in the absence of transaction costs. This gives the ‘string of sausages’ shape shown in Figure 4. See the text for details of parameters. t) = W S + δ(µ − r ) γ Sσ 2 and δ(µ − r ) ± γ Sσ 2 δ(µ − r ) ± γ Sσ 2 ∗ 3SδyS 2γ 2 1/3 y = WS + 1/3 = WS + 1/3 3Sδ δ(µ − r ) W SS − 2γ γ S2σ 2 2 1/3 where W is the Black–Scholes call value. These three curves are given by y = y ∗ (S.

4) has required the solution of (3.1. at the two turning points dy ∗ becomes deterministic and of higher order.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 321 FIGURE 4. In deriving these plots we have not had to solve any differential equation since the functions y ∗ and Y + depend only on W . Away from turning points dy ∗ is of the same order as d S. γ = 1. With the same cost structure as above it is readily found that for a short . This is the bold curve. This plot (and Figure 4.0. Again these O( 2/3 ) and O( ) curves are similar in magnitude.3 with S = 19. The difference between the asymptotic limit of the Davis et al. and µ = 0. model and the Black–Scholes value. model and the Black–Scholes call option value. This is the bold curve and is the sum of the lower two curves. the Black–Scholes call value. We now move on to another example. let us recall the model of Leland (1985) and of Hoggard et al..4 we plot the time dependence of the difference between the asymptotic limit of the Davis et al. model and the Black–Scholes value for a European call. The bold curve is the sum of the other two curves. We consider a European call with exercise price 20 and with up to three years until expiry. (1994). This is because they differ by a factor of order O( 1/3 ) which for = 0. The solution shown in Figure 4.11). See the text for details of parameters. The plot in Figure 4. also plotted. The parameters in this case are = 0. for the same parameters as in Figure 4.05. To ﬁnish this paper. However.002.085.13 and not very small. The option is then valued so as to give the hedged portfolio the same expected return as that from a bank. Note that the O( 2/3 ) and the O( ) curves are similar in magnitude. and these two curves are also shown in the ﬁgure. r = 0. Thus it is possible to impose tighter bounds on the no-transaction region and this is exactly what is seen.3 shows the difference between the asymptotic limit of the Davis et al. Nevertheless this asymptotic solution shows very good agreement with the numerical results of Davis et al. The bold curve is the sum of the other two curves. the O( 2/3 ) part and the O( ) part. It has two components. In Figure 4. σ = 0.002 is 0. In that model it is assumed that a delta-hedged portfolio is rehedged every ﬁxed time period δt.3 was computed by a simple explicit ﬁnite-difference scheme and thus took approximately the same time to run as the binomial solution of an American option.3.

t) = W (S. Numerical results taken from Davis et al. E. With V (S. 2 π δt (3.15) V2t + r SV2S + with V2 (S. All of them give the Black–Scholes value to leading order with a smaller order correction. In that model the investor delta hedges with rehedging determined by ‘market movements. t) + · · · we have σ 2 S2 2 V2SS − r V2 = − σ S 2 |W SS | . WHALLEY AND P. position Vt + r SVS + σ 2 S2 2 VSS − r V = − σ S 2 |VSS | .16) with V2 (S. T ) = 0. t) + V2 (S. This models a strategy commonly used in practice. 2 π δt By writing V (S. The unlabeled bold curve is the sum of the lower two curves. t) = W (S. t) which speciﬁes the hedging bandwidth must be prescribed by the investor. t) + · · · it is found that this time the correction term for a short position satisﬁes V2t + r SV2S + σ 2 S2 σ 2 S4 2 V2SS − r V2 = − 1/2 W SS . but in all cases satisﬁes an ‘inhomogeneous Black–Scholes-type . The function d(S. Now recall the model of Whalley and Wilmott (1993).4. model and the Black–Scholes value for a European call as a function of time to expiry. WILMOTT FIGURE 4. T ) = 0. are also shown. t) + V2 (S.’ If the difference between the delta and the number of assets actually held becomes greater than d(S. The option value is again determined by assuming that the expected return is equal to the risk-free rate. This correction differs between models. Now we can see the similarities between the three different models.322 A. t)/S then the portfolio is rehedged to the delta value giving the portfolio the minimum variance. 2 d (3. The difference between the asymptotic limit of the Davis et al.

. AND A. New York: Cambridge University Press. 470–493. PANAS.-L.. Since the right-hand side of the V2 equation is in each case a nonlinear function of the Black–Scholes value of gamma. E. A. ATKINSON. E. WILMOTT (1994): “Hedging option portfolios in the presence of transaction costs. AND P.” J. then for small asset values the call option can have a negative value. Political Economy. 47. W SS . Thus. REFERENCES 1. 40. 637–54.” Adv.” Rev. there will inevitably be different values for short and long positions. Also portfolios of options must be treated as a whole and not as the sum of individually valued components. However. 357–367. Finance. BOYLE. H. T. J. 81. Brieﬂy. S. D. This entails at least knowing all of his estimates of the parameters. F. With the more general costs structure discussed in Hoggard et al. Control Optim. J. A. model. HOGGARD.” SIAM J.’ where the extra term resulting from the transaction costs depends on some power of the Black–Scholes option gamma (W SS ). S. and Whalley and Wilmott (not simply bid–offer spread) it is possible to arrive at negative option prices. HODGES. V. GROSSMAN. these include the following. Futures Markets. Finance. 2. From the point of view of the numerical solution of these equations we can say that the inhomogeneous equations will not take signiﬁcantly longer to solve by ﬁnite-difference methods than the basic inhomogeneous Black–Scholes equation. This introduces a free boundary below which (for a call) the option should not be rehedged. DAVIS. 3. If a ﬁxed amount is paid at each rehedge. E. 31. by performing this simple asymptotic analysis of the Davis et al. Res. SCHOLES (1973): “The pricing of options and corporate liabilities. As also mentioned in Davis et al. we have made its use a practical possibility. In Whalley and Wilmott (1993) many issues arising from such equations are discussed. ZARIPHOPOULOU (1993): “European option pricing with transaction costs. LELAND. Finance. AND M. (1985): “Option pricing and replication with transaction costs. 271. 8. ZARIPHOPOULOU (1990): “Optimal portfolio rebalancing with transaction costs. C.” Math. (To see this. Negative option prices. WILMOTT (1995): “Portfolio management with transaction costs: An asymptotic analysis. VILA.) This suggests modifying hedging strategies to allow the possibility of not rehedging if to rehedge would make the option value negative. . BLACK. Division of Applied Mathematics.. 5.” J. 7.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 323 equation. VORST (1992): “Option replication in discrete time with transaction costs. NEUBERGER (1989): “Optimal replication of contingent claims under transaction costs. M. 1283– 301. P. Futures Opt.” J. it is unlikely that the simple bid–offer spread considered here would lead to negative option prices. Brown University. 21. (1991): Perturbation Methods. AND T.” Working paper. AND T. 222–239. P. WHALLEY.. G. H. AND P. HINCH.. FLEMING. AND T. Nonlinearity. H. American options. D. W. It is difﬁcult to optimally value an American option unless the owner’s hedging and exercise strategy is known. consider the commission component of costs. it is the owner of the American option who controls its exercise.

Oxford. PLISKA (1995): “Optimal portfolio management with ﬁxed transaction costs. “A hedging strategy and option valuation model with transaction costs. WHALLEY AND P.” OCIAM Working paper. Fin.” Appl.. B. 337–356. SHREVE. (1994): “Simulations of transaction costs and optimal rehedging.. AND S. M. Finance.” Math. E. SONER (1994): “Optimal nvestment and consumption with transaction costs. A. 5. E. 1. WHALLEY. WILMOTT MOHAMED. S. . AND P. Applied Prob. 49–63. A. Math. E. MORTON. WILMOTT (1993). AND H. Mathematical Institute. 680–692. 4.” Ann.324 A.

[Carr, Chesney] American Put Call Symmetry (NOV1996)

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