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[Whalley, Wilmott] an Asymptotic Analysis of an Optimal Hedging Model for Option Pricing With Transaction Costs (Jul1997)

[Whalley, Wilmott] an Asymptotic Analysis of an Optimal Hedging Model for Option Pricing With Transaction Costs (Jul1997)

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Mathematical Finance, Vol. 7, No.

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


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

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

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

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

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

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


2
S
4
σ
3
y

2
S

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

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


2
S
4
σ
3

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

2/3
δ(µ −r)
4/3
γ
.
This has solution with zero final data
V
2
=
1
2

3

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

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

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

1/3
=
δ(µ −r)
γ Sσ
2
±
1/3


3
(µ −r)
2

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

1/3
= W
S
+
δ(µ −r)
γ Sσ
2
±
1/3

3Sδ

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. amounting to the payoff function for the option in question. In Section 4 we compare the model with others and draw conclusions. For example. In Section 2 we very briefly describe the model of Davis. In common with the Davis. t is time. WHALLEY AND P.308 A. 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. the technique has. . In the presence of costs. Perturbation analysis is a very powerful tool of applied mathematics. This equation must be solved for t < T and 0 ≤ S < ∞. On t = T we must impose a final condition. 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). for a call option with strike price E we have W (S. We shall continue to use W to denote the Black–Scholes value of a European option. For comparison. Panas. for an asymptotic analysis of the Morton and Pliska (1995) portfolio management problem with transaction costs. and Zariphopoulou (1993) model.1) Wt + r SW S + σ 2 S2 W SS − r W = 0. see Atkinson and Wilmott (1993). THE MODEL OF DAVIS. Panas. Panas. rarely been used in finance. We show how. t) is the value of an option. For this reason. and found to be the best strategy he tested. and Zariphopoulou (1993).or four-dimensional free boundary problems. r the interest rate. and W (S. we are initially considering the valuation of a short European call option. in the limit of small transaction costs. because it reveals the salient features of the problem while remaining a good approximation to the full but more complicated model. and Zariphopoulou (1993) the writing price of a European option is defined in terms of a utility maximization problem. WILMOTT The models are slow to compute since they usually result in three. 0). This is the problem to be solved in the absence of costs. When there are no costs this results in the Black–Scholes value for the option (Black and Scholes 1973). Panas. assumed deterministic. 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. AND ZARIPHOPOULOU In the model of Davis. There is great practitioner resistance to the idea of utility theory. In this paper we perform a simple asymptotic analysis of the Davis. We thus bring together the competing philosophies behind modeling transaction costs. 2. 2 Here S is the underlying asset price. Recall that in the absence of transaction costs the Black–Scholes equation for the value of an option is (1. T ) = max(S − E. and Zariphopoulou paper. Simply put. As yet. In Section 3 we consider the asymptotic limit of small transaction costs. we shall at times walk the reader very slowly through the calculations. σ the volatility of the underlying. It is used to great effect in areas such as fluid mechanics (Hinch 1991). E. This results in an inhomogeneous diffusion equation for the price of an option. to our knowledge. PANAS.

y. For options with delivery of the asset on exercise the analysis below remains the same. find that the option price V (S. t) both satisfy the following equation γ (1 + )S Q ∂Q γ (1 − )S Q ∂ Q ∂Q σ 2 S2 ∂ 2 Q ∂Q + . The independent variable y measures the number of shares held in the optimally hedged portfolio. for a call option (2. 0. the final conditions merely alter.1 or more generally commissions and costs that are proportional to the value of the assets traded.1) where T is the expiry date. T ) = exp(−γ c(S. y) + E − S)) S≤E S>E Q 1 (S. t) is given by V (S. y) = (1 + )y S (1 − )y S y<0 y ≥ 0. t) and Q w (S. min Here measures the transaction costs: A trade of N shares will result in a loss of N S. 1 Davis et al. 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.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. δ(T. t) = δ(T. The two functions Q 1 and Q w must satisfy certain final conditions. Q 1 (S. y)) exp(−γ (c(S. + µS + ∂y δ ∂y δ ∂t ∂S 2 ∂ S2 = 0. consider the slightly more general case in which there are different levels of cost for buying and selling. Finally.3) where c(S. t) = e−r (T −t) . 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). to fully pose the problem we must specify that for t < T .2) and (2. analogous to the payoff profile of the option. y. Note we are assuming here that the option is settled in cash. . Q. 0. t) (2. y. and Q 1 (S. This cost structure represents bid–offer spread. where µ and σ are constant and X is a Brownian motion. y. Q w (S. t) . ∂ Q/∂ S. − − . T ) = exp(−γ c(S. t) log γ Q w (S. for example. and ∂ 2 Q/∂ S 2 must all be continuous.

y) space showing the buy. 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.1. this curve is denoted by y = y ∗ (S. A schematic diagram of (S. The writer of the option must always maintain his portfolio in the region of the (S. t). y) space bounded by the two outer curves. E. y) space divides into three regions.310 A.1 is the curve along which the investor must move in the absence of transaction costs. It is explained by Davis et al. If he hits the top boundary he must sell shares. We shall find simple analytical expressions for all three of these curves.5) γ (1 − )S Q ∂Q + = 0. sell.4) In the sell region we have (2. shown schematically in Figure 2. WHALLEY AND P. The middle line in Figure 2. Both y ∗ and the position of the upper and lower boundaries are to be found. while inside this region he does not transact. In the buy region we have γ (1 + )S Q ∂Q + = 0. WILMOTT FIGURE 2. This is a free boundary problem. ∂y δ . if he hits the bottom boundary he must buy shares.1. ∂y δ (2. how the (S. and no-transaction regions.

The two expressions (3. we shall not find the general solution. Because the two problems for Q 1 and Q w are identical except for the final data. an arbitrary function of S and t that comes from solving the ordinary differential equation (2. Indeed. ∂ Q/∂ S.5) to get γ Sy γS y + + H + (S. and ∂ 2 Q/∂ S 2 must all be continuous. First. y.3) Q = exp − SY + δ 1/3 H1 (S. we shall see how such a choice is the natural one. Y. t. In the sell region we can similarly solve (2. t) + · · · . t) in the buy region is found to be (3. and Zariphopoulou (1990) have also obtained this . t) − δ 4/3 1/3 γ (3. we have chosen to expand in powers of 1/3 . There are two very important things to note about this expression. + µS + ∂t ∂S 2 ∂ S2 (2.4): in this equation S and t are effectively parameters. 3.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 311 In the no-transaction region we have ∂Q σ 2 S2 ∂ 2 Q ∂Q = 0. t.4) and (2.1) Q = exp − γS y γ Sy − + H − (S.6) This is the free boundary problem we shall shortly solve asymptotically. Y. as yet. t) + H3 (S. δ δ (3. t) + 2/3 H2 (S.6).4) is very easy to solve explicitly. t) + H4 (S. 1994. The first stage in determining this solution is to expand Q in an asymptotic series in powers of . t) + 5/3 H5 (S. The solution in the no-transaction region is much harder to find. rather we shall find the asymptotic solution valid for small . ) δ δ where H − is. ASYMPTOTIC ANALYSIS FOR SMALL LEVELS OF TRANSACTION COSTS Equation (2. general solutions of (2. and notes that Fleming. Grossman.1) and (3.1) Q.2) are the exact. As we perform our analysis. We write the solution in the no-transaction region as γ Sy ∗ + H0 (S.2) Q = exp − This contains another arbitrary function H + . When we come to apply the final data we will distinguish between Q 1 and Q w as necessary. As mentioned above. ) . The solution for Q(S. across the two free boundaries (the outer curves in Figure 2. we need only perform the analysis for one of them. This is not an arbitrary choice. Vila. (Shreve and Soner. 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.

Y turns out to be a more natural variable to use than y. t) + yS . t) γS − H4Y δ 1/3 γ Y 4/3 H4t (S. We shall see. t) + 2/3 H2S (S.4) y = y ∗ (S. 4/3 ∗ H4S (S. t) + 2/3 H2t (S. 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.1) and (3.2) and continuity of slope at the boundary of the no-transaction region. ∂Y ∂ ∂ → − ∂S ∂S ∂ ∂ → − ∂t ∂t Thus we readily find from (3. t) + yt∗ + · · · Q.3). t) γS − H4Y δ + · · · Q.) Second. t) + 1/3 Y. We shall find an explicit expression for y ∗ as a function of S and t.3) and (3.4) that −1/3 ∗ yS ∂ .1). E. The former is forced by the leading terms in (3.3) does not satisfy the equation in the no-transaction region. It is such continuity requirements that actually force on us the special choice of 1/3 . Since the derivatives in (2. ∂Y γ Syt∗ r γ Sy ∗ ∂Q ≡ Qt = − + H0t (S. t) + H3t (S. in performing this analysis. WHALLEY AND P. We must now find the functions Hi such that this equation and all relevant boundary and smoothness conditions are satisfied. we have translated the y coordinate according to (3. As yet (3. Observe how. t) + + ∂t δ δ + + 1/3 1/3 r γ SY δ H1t (S. t) − − ∂S δ δ δ + + 1/3 H1S (S.6) are with respect to t and S keeping y fixed. y ∗ . there is Y dependence at O( 1/3 ) and O( 4/3 ). t) + H3S (S. then ∂ → ∂y −1/3 ∂ . WILMOTT scale. ∗ γ SyS γ y∗ ∂Q ≡ QS = − + H0S (S. 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).312 A. that the choice of a series expansion in powers of 1/3 is inevitable. in (3. The reason for the latter is similar and the details will become apparent. Thus Y is a rescaled variable (see Figure 2. ∂Y −1/3 ∗ yt ∂ . Y. Y.

Q SS = H0SS + H0S − γ y∗ δ 2 Q. to leading order equation (2. We have retained them in this form to help the reader perform his own calculations. 2 ∗ + H3SS (S. t) + yS 1/3 γS − H4Y δ + ··· Q + H0SS (S. The O(1) Equation To leading order (O(1)) we find that r γ Sy ∗ δ Qt = H0t + Q. t) 2 + 2/3 ∗ H2S (S. t) + 2/3 H2SS (S. 2 3. The advantage of asymptotic analysis will now become clear when we perform the next step.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 313 and ∗ γ SyS γ y∗ ∂2 Q ≡ Q SS = − + H0S (S. t) + H3S (S. We find that H0S − γ y∗ σ 2 S2 + H1SS = 0. Thus. 3.6) and equate powers of 1/3 . to substitute these expressions into (2. equating powers of γY γY r γ SY + H1t +µS − + H1S +σ 2 S 2 − + H1S δ δ δ . t) + H1SS (S. t) − ySS H4Y + 2/3 ∗2 yS H4Y Y It will be observed that each of the above can be slightly simplified.5) H0t + + σ 2 S2 2 H0S − γ y∗ δ 2 + σ 2 S2 H0SS = 0.2. t) ∗ ∗ − 2 yS H4Y S + ys H5Y Y + · · · Q.1.6) becomes r γ Sy ∗ γ y∗ + µS H0S − δ δ 1/3 (3. QS = H0S − γ y∗ δ Q. The O( ) Equation 1/3 We can take this procedure to the next order. t) − − ∂ S2 δ δ 1/3 γ Y δ + 1/3 H1S (S. δ 2 .

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

and set V1 = δ H1 /γ as above. we find that V1 satisfies the Black–Scholes equation.1) and (3. 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. − and 2Y − ∗2 σ 2 S 2 yS 2 The γS δ on Y = Y + γS δ on Y = −Y − . V1 is identically zero for all S and t < T .) Thus.3.6). As stated previously. H2SS + yS H4Y Y + 2 2 2δ 2 This is an ordinary differential equation2 for H4 which is easily integrated to give H4 (S. unknown and must be determined as part of the solution by imposing suitable smoothness conditions. t) and −Y − (S. proportional to Y 2 . 3.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL ∗ 315 y If we substitute for H0S − γ δ using (3. The final condition for this equation for both Q w and Q 1 is V1 (S. we require Q and its first two derivatives with respect to Y to be continuous at Y = Y + and Y = −Y − . If we examine the O( 2/3 ) terms in (2. (This is found by expanding the final conditions in powers of 1/3 and considering the terms of O( 1/3 ). and so the leading order correction to the Black–Scholes value occurs at the O( 2/3 ) level. 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 . we find that H2t + r S H2S + σ 2 S2 σ 2 S 2 ∗2 γ 2σ 2 S2Y 2 = 0. at this order has forced Y dependence in H4 . We now have to join this solution in the no-transaction cost region with the solutions (3.2) in the buy and sell regions respectively. Y.1) and (3.8). 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.2) we can see that continuity of the gradient of Q at Y = Y + and Y = −Y − is ensured by H4Y = and H4Y = − Thus. From (3. . of course. t) = 0. Let us use the notation Y + (S. t) to denote the Y -coordinates of the boundaries of the no-transaction region. δ inhomogeneous term. These are.

By letting H2 = we can write (3. Y − = Y + . are given by (3. As far as implementation of the optimal hedging is concerned. We also find that the edges of the ‘hedging bandwidth.9) H2t + r S H2S + .316 A. at Y = Y + and Y = −Y − . and Q 1 .e. that is. T ) = 0.6). 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. the problem without the option.3 Thus. WHALLEY AND P. . via equation (3. These are given by very simple analytic expressions in terms of yS . E.10). which in turn is simply related to the option’s gamma by equation (3.. as in Black–Scholes.− ∗ δ 2 yS 2 2 and a = 0.11) 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 . 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. We conclude from this that the no-transaction region is to leading order symmetric about the Black–Scholes hedging strategy. zero. The V2 component of Q 1 3 Recall that the number of the underlying asset held contains a term V . to leading order.9) as σ 2 S2 δ V2SS −r V2 = − 2 2γ 3γ 2 S 4 σ 3 2δ 2 2/3 γ V2 (S. 2 ∗ σ 2 S 2 yS 2 σ 2 S2 H2SS H2t + r S H2S + 2 =− γ 2 Y +.9) is to be solved subject to the final condition H2 (S. i.10) Y+ = Y− = ∗ 3SδyS 2γ 2 1/3 . If this were not the case then there could be no finite value for the option price. the problem including the option liability. We cannot stress the importance of this last result enough.’ Y = Y + and Y = −Y − . We shall see this more clearly in the final section of this paper. t) δ (3. WILMOTT The second derivative of Q with respect to Y must also be continuous. to leading order. we need to know the boundaries of the no-transaction ∗ region.

t) = W (S.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...11) with V0SS = W SS . given sufficient boundary conditions.e. recall that we must have continuity of first and second derivatives with respect to Y at all orders of . γ Using W (S.3). σ 2 S2 1 V2SS − r V2 = − 2 2 3 2σ 2/3 V2t + r SV2S + δ(µ − r )4/3 . as a partial differential equation for H3 (just as in the H2 .13) H4Y + 1/3 H5Y = ± γS δ on the top and bottom free boundaries. i.6) give σ 2 S2 ∗ ∗ H3SS − ySS H4Y − 2yS H4Y S 2 2γ Y H2S δ = 0. Thus (3. The O( ) terms in expression (2. Thus we see that the option value correct to O( 2/3 ) is simply 2/3 V (S. We can thus take the asymptotic analysis even further. To determine the correct boundary conditions. γ This has solution with zero final data 1 2 3 2σ 2/3 V2 = δ(µ − r )4/3 (T − t) .4. where V2 satisfies (3.e. t) − 1 2 3 2σ δ(µ − r )4/3 (T − t) γ + ···. i. t) + 2/3 V2 (S. 3. H4 problem of Section 3. W SS . By going to higher order we must also expand the position of the free boundaries as power series in 1/3 .11) with V0SS being the Black–Scholes value for the gamma. The O( ) Equation It is remarkable that the algebraic complexity of the problen is still manageable at the O( ) level. (3.11) with V0SS = 0. 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. Transferring the boundary condition .

14) σ 2 S2 H3SS = 0 2 (since −Y − H4Y dY = 0). σ2 .2) and (2. We have H − = H0 + 2/3 H2 + H3 + γS ∗ y . t)+ 2/3 V2 (S.1) we now have 1 2 3 2σ 2/3 V (S.13) onto the known leading order boundaries y = Y + and y = −Y − . t) = W (S. H3 (S. . we find that H5Y = 0 on y = Y+ and y = −Y − . Now integrate (3. t)− δ(µ − r )4/3 (T − t) + SW S + O( γ 4/3 ). T ) = (µ − r ) . t) = exp(H − ). for both the 1 and the w problems. From (2. E.3) in powers of this final data is simply H3 (S.318 A. With H3 = γ V3 /δ we can now see that V3 satisfies the Black– Scholes equation. 0. We find that H3t + r S H3S + Y+ (3. we need the result Q(S. The solution of (3. WHALLEY AND P. σ2 1/3 This is found by expanding (2. The final data for this equation is.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. WILMOTT (3. since the option value depends on Q(S. 0. where V2 satisfies (3. t). and that the final condition incorporates any transaction costs payable at maturity in order to unwind the hedge. 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.12) from y = −Y − to y = Y + . since H4Y Y = 0 on y = Y + and y = −Y − . t) = (µ − r ) . δ Finally.

The hedge ratio and no-transaction band as functions of S without the option liability.1. Recalling our expressions for y ∗ . is the middle curve. model and make comparisons with their numerical results. Other parameters are r = 0. these three curves are given by δ(µ − r ) γ Sσ 2 y = y ∗ (S. First.10). we consider a European call option with exercise price E = 0. σ = 0. The outer.1. The solution in the absence of costs.0.002. equation (3.2.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 319 FIGURE 4.1 we plot the solution for y ∗ and the hedging boundaries against S for the first problem (denoted by subscript 1). and γ = 1. To be specific we have concentrated on examples given in Davis et al. The level of transaction costs is such that = 0. 4. y ∗ . In Figure 4.3. bold curves are the boundaries of the no-transaction region when there are nonzero transaction costs as detailed above.6).5 and time to expiry 0.07. µ = 0. and Y + and Y − . which does not have the option liability at expiry. 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 . See the text for details of parameters. . equation (3. RESULTS AND CONCLUSIONS In this section we give the results of our asymptotic limit of the Davis et al.

we have ∗ dy ∗ = yS d S + · · · . . The hedge ratio and no-transaction band as functions of S for the problem with the option liability. the solution in the absence of transaction costs. WILMOTT FIGURE 4. E. 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. is the middle curve and two bold curves are the boundaries of the no-transaction region. See the text for details of parameters. to leading order. which includes the option liability at expiry. In Figure 4. At the two turning points of y ∗ . This result has an obvious financial interpretation.2.320 A. Because y ∗ has turning points. In stochastic terms. This plot is of particular interest. the width of the no∗ transaction region (which is proportional to (yS )2/3 ) goes to zero. Again y ∗ . a relatively large change in the share price can be tolerated before rehedging is necessary. These three curves are given by y = y ∗ (S. WHALLEY AND P. This gives the ‘string of sausages’ shape shown in Figure 4.2.2 we plot the equivalent solutions for the second problem (denoted by the subscript w).

This plot (and Figure 4.3 with S = 19. It has two components. To finish this paper.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. the O( 2/3 ) part and the O( ) part.3. (1994). In Figure 4. Again these O( 2/3 ) and O( ) curves are similar in magnitude. The bold curve is the sum of the other two curves. γ = 1.ASYMPTOTIC ANALYSIS OF AN OPTIMAL HEDGING MODEL 321 FIGURE 4. also plotted. However. With the same cost structure as above it is readily found that for a short .1.11).. and µ = 0.4 we plot the time dependence of the difference between the asymptotic limit of the Davis et al. In deriving these plots we have not had to solve any differential equation since the functions y ∗ and Y + depend only on W . We consider a European call with exercise price 20 and with up to three years until expiry. We now move on to another example. the Black–Scholes call value. In that model it is assumed that a delta-hedged portfolio is rehedged every fixed time period δt.05.4) has required the solution of (3. model and the Black–Scholes value. σ = 0. The difference between the asymptotic limit of the Davis et al.3 shows the difference between the asymptotic limit of the Davis et al. This is the bold curve. The parameters in this case are = 0.085. Nevertheless this asymptotic solution shows very good agreement with the numerical results of Davis et al.13 and not very small. The solution shown in Figure 4. and these two curves are also shown in the figure. model and the Black–Scholes call option value. Thus it is possible to impose tighter bounds on the no-transaction region and this is exactly what is seen.0. This is because they differ by a factor of order O( 1/3 ) which for = 0. for the same parameters as in Figure 4. This is the bold curve and is the sum of the lower two curves.002. The option is then valued so as to give the hedged portfolio the same expected return as that from a bank. The bold curve is the sum of the other two curves. let us recall the model of Leland (1985) and of Hoggard et al. The plot in Figure 4. Note that the O( 2/3 ) and the O( ) curves are similar in magnitude. model and the Black–Scholes value for a European call. Away from turning points dy ∗ is of the same order as d S.002 is 0. at the two turning points dy ∗ becomes deterministic and of higher order. r = 0. See the text for details of parameters.

E. Numerical results taken from Davis et al. t) = W (S. t) + V2 (S. but in all cases satisfies an ‘inhomogeneous Black–Scholes-type . position Vt + r SVS + σ 2 S2 2 VSS − r V = − σ S 2 |VSS | .’ If the difference between the delta and the number of assets actually held becomes greater than d(S. This correction differs between models. The unlabeled bold curve is the sum of the lower two curves.322 A. The option value is again determined by assuming that the expected return is equal to the risk-free rate. 2 π δt By writing V (S. model and the Black–Scholes value for a European call as a function of time to expiry. t) which specifies the hedging bandwidth must be prescribed by the investor. WILMOTT FIGURE 4. t) = W (S. t) + · · · we have σ 2 S2 2 V2SS − r V2 = − σ S 2 |W SS | . 2 π δt (3. All of them give the Black–Scholes value to leading order with a smaller order correction. The difference between the asymptotic limit of the Davis et al. This models a strategy commonly used in practice.16) with V2 (S. T ) = 0. The function d(S. With V (S.4. WHALLEY AND P. are also shown. T ) = 0. 2 d (3. Now recall the model of Whalley and Wilmott (1993). Now we can see the similarities between the three different models. 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 . In that model the investor delta hedges with rehedging determined by ‘market movements.15) V2t + r SV2S + with V2 (S. t)/S then the portfolio is rehedged to the delta value giving the portfolio the minimum variance. t) + V2 (S.

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

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

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