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# Math. Meth. Oper. Res.

(2006) 64: 227–236
DOI 10.1007/s00186-006-0086-0
ORIGINAL ARTICLE
Miklavž Mastinšek
Discrete–time delta hedging
and the Black–Scholes model
with transaction costs
Received: 6 April 2005 / Accepted: 3 March 2006 / Published online: 5 August 2006
Abstract The paper deals with the problem of discrete–time delta hedging and
discrete-time option valuation by the Black–Scholes model. Since in the
Black–Scholes model the hedging is continuous, hedging errors appear when
applied to discrete trading. The hedging error is considered and a discrete-time
adjusted Black–Scholes–Merton equation is derived. By anticipating the time sen-
sitivity of delta in many cases the discrete-time delta hedging can be improved and
more accurate delta values dependent on the length of the rebalancing intervals can
be obtained. As an application the discrete-time trading with transaction costs is
considered. Explicit solution of the option valuation problem is given and a closed
form delta value for a European call option with transaction costs is obtained.
Keywords Delta hedging · Transaction costs
1 Introduction
The option valuation problem with transaction costs has been considered exten-
sively in the literature. In many papers on option valuation with transaction costs
the discrete-time trading is considered by the continuous-time framework of the
Black–Scholes–Merton partial differential equation (BSM-pde); see e.g. [Leland
1985; Boyle and Vorst 1992; Hoggard et al. 1994; Avellaneda and Paras 1994;
Toft 1996]. Since in continuous-time models the hedging is instantenuous, hedg-
ing errors appear when applied to discrete trading. In that case perfect replication
is not possible, hence reducing the error is important for application.
The hedging error, deﬁned as the difference between the return to the port-
folio value and the return to the riskless asset over the rebalancing (rehedging)
M. Mastinšek
Faculty of Economics and Business, University of Maribor,
Razlagova 14, 2000 Maribor, Slovenia
E-mail: mastinsek@uni-mb.si
228 M. Mastinšek
interval, depends on the length δt of the interval. When rebalancing intervals are
relatively small and thus trading takes place very frequently, then the expected
hedging error may be relatively small. For the analysis of the hedging error in
the case where option values are described by the BSM-pde; see e.g. [Boyle and
Emanuel 1980; Toft 1996; Mello and Neuhaus 1998]. However in presence of trans-
action costs more frequent trading may increase the accumulated costs considerably
[Korn 2004; Kocinski 2004].
In continuous-time models the value of delta representing the number of shares
held in the portfolio varies continuously with time. If V(t, S) is the option value
at time t and S the price of the underlying asset, then the delta value at time t is
given by the partial derivative V
S
(t, S) of the current value of V; see e.g. [Black
and Scholes 1973; Merton 1973].
In practice where the trading takes place discretely in time, the number of
shares given by the delta is held constant over the rebalancing interval and thus
the hedging error cannot be eliminated. This means that reducing the risk and the
hedging error is of main practical interest. In the case when δt is sufﬁciently small,
the current value of delta gives an acceptable value such that the hedging error is
small. However, when the rebalancing is not that frequent, due to transaction costs
for instance, then in general the hedging error will not be small. Moreover, if the
delta is more sensitive with respect to time, the error will further increase.
In the papers of Leland and others, which consider the option pricing prob-
lem with transaction costs by the Black–Scholes model, the number of shares kept
constant is given by the Black–Scholes delta at time t regardless of the time between
successive rehedgings and the time sensitivity of delta..
In this paper the time between rehedgings and the time sensitivity of delta
is considered. The objective is to incorporate the time change of delta over the
rebalancing interval into the model implicitly so that the resulting equation can
be directly transformed to the BSM pde and solved as the diffusion equation. In
this way the number of shares kept constant between successive rehedgings can be
derived explicitly by the BSM pde adjusted to discrete-time trading. A closed form
discrete-time delta dependent on the interval length δt can be obtained. Short notes
on further research and improvements of discrete hedging are given. As an appli-
cation the case of option valuation with transaction costs is treated and explicitly
solved.
The paper outline is as follows: in Sect. 2 the portfolio over the rebalanc-
ing interval is studied. The discrete-time adjusted Black–Scholes–Merton partial
differential equation is derived and appropriate values for discrete-time hedg-
ing are given. In Sect. 3 the option valuation problem with transaction costs is
considered and an appropriate equation describing the process is obtained. A
speciﬁc example of a European call option is studied and a closed form
representation of the discrete-time delta is given.
2 Discrete-time Black–Scholes–Merton partial differential equation
Let us denote by V = V(t, S) the option value as a function of the underlying
asset with price S and time t. Suppose that the price of the underlying at time t is
given by
S(t ) = S
0
exp(νt +σW(t )), (2.1)
Discrete–time delta hedging and the Black–Scholes model with transaction costs 229
where W(t) is the Wiener process (Brownian motion), σ the annualized volatility
andμ = ν+(1/2)σ
2
the expectedannual rate of return. Thenthe change of S =S(t )
over the small noninﬁnitesimal interval of length δt is approximately equal to
δ S = S(t +δt ) − S(t ) = σ SZ

δt +μ Sδt, (2.2)
where Z is normally distributed variable with mean zero and variance one; in short
Z ∼ N(0, 1) (Leland 1985; Hull 1997)
Let be the value of a portfolio at time t consisting of a long position in the
option and a short position in N(t) units of shares with the price S
= V − N(t )S. (2.3)
In the continuous-time model where the hedging is instantanuous and the repli-
cation is perfect, the number of shares N(t) is given by the current value of the
derivative V
S
(t, S) (the delta), where V(t, S) is the solution of the Black–Scholes–
Merton equation.
In practice where the trading takes place discretely in time, the number of
shares given by the delta is held constant over the rebalancing interval (t, t +δt ).
Thus when continuous-time models are applied to discrete-time trading, hedging
errors appear. The hedging error, deﬁned as the difference between the return to
the portfolio value and the return to the riskless asset over the rehedging inter-
val, depends on the length δt of the interval. This means when δt is sufﬁciently
small, the current value of the derivative gives an acceptable approximation for
the discrete-time hedging with small error. However, when the rebalancing is not
frequent, especially in the case where the delta is sensitive with respect to time,
higher errors may occur (cf. Remark 2.2). For the mean-variance analysis of the
error, where Vis given by the BSMequation (Boyle and Emanuel 1980; Toft 1996).
Remark 2.1 Suppose that after discrete hedging, for instance from a time point
t +δt to expiry, continuous hedging is assumed. Then the delta value at time t +δt
is determined by the partial derivative V
S
(t +δt , S+δS) where V(t,S) is the solution
of the Black–Scholes–Merton equation. In that case for example the constant value
of delta over the rehedging interval (t, t +δt ) can be approximated by V
S
(t +δt, S).
In the continuation we will consider the case, where hedging is in discrete time
until expiry. We assume that hedging takes place at equidistant time points with
rebalancing intervals of (equal) length δt . Throughout we assume that partial deriv-
atives of V(t, S) are continuous functions on their respective domains. Moreover
we let the trading be relatively frequent so that the interval length δt is relatively
small. Then we have
Proposition 2.1 Let V = V(t, S) be the option value at time t and price S. Let
σ be the annualized volatility and r the annual interest rate of a riskless asset
continuously compounded. If the approximate number of shares N(t ) held short
over the rebalancing interval of length δt is equal to:
N(t ) = V
S
(t +δt, S), (2.4)
where V(t, S) satisﬁes the Black–Scholes–Merton equation
V
t
(t, S) +
1
2
σ
2
0
S
2
V
SS
(t, S) +r
0
SV
S
(t, S) −r
0
V(t, S) = 0 (2.5)
230 M. Mastinšek
with parameters
σ
0
= σ
_

1 +rδt and r
0
=
r
_
1 +rδt
, (2.6)
then the mean and the variance of the hedging error is of order O(δt
2
).
Proof Let us consider the return to the portfolio over the period [t, t + δt ],
t ∈ [0, T − δt ]. By assumption over the period of length δt the value of the
portfolio changes by
= V − N(t )δS (2.7)
as the number of shares N(t) is held ﬁxed during the time step δt .
First we consider the change V of the option value V(t, S) over the time
interval [t, t + δt ] of length δt . We give the Taylor series expansion of the
difference in the following way:
V = V(t +δ t, S +δ S) − V(t, S)
= (V(t +δ t, S +δ S) − V(t +δ t, S))
+(V(t +δ t, S) − V(t, S)) = I + I I (2.8)
where:
I = (V(t +δ t, S +δ S) − V(t +δ t, S))
= V
S
(t +δ t, S)(δ S) +
1
2
V
SS
(t +δ t, S)(δ S)
2
+
1
6
V
SSS
(t +δ t, S)(δ S)
3
+ O(δt
2
), (2.9)
and
I I = (V(t +δ t, S) − V(t, S)) = V
t
(t +δt, S)(δ t ) + O(δt
2
). (2.10)
By (2.2) we get the approximation
V = V
t
(t +δt, S)(δ t ) + V
S
(t +δ t, S)(δ S)
+
1
2
V
SS
(t +δt, S)(δ S)
2
+
1
6
V
SSS
(t +δt, S)(δ S)
3
+ O(δt
2
)
= V
t
(t +δt, S)(δ t ) + V
S
(t +δ t, S)(δ S)
+
1
2
V
SS
(t +δt, S)(σ SZ

δt +μ Sδ t )
2
+
1
6
V
SSS
(t +δt, S)(σ SZ

δt +μ Sδ t )
3
+ O(δt
2
) (2.11)
hence
V = V
t
(t +δt, S)(δ t ) + V
S
(t +δ t, S)(δ S)
+
1
2
V
SS
(t +δt, S)
_
σ
2
S
2
Z
2
δt +2σμ S
2
Zδ t
3
2
_
+
1
6
V
SSS
(t +δt, S)σ
3
S
3
Z
3
δt
3
2
+ O(δt
2
). (2.12)
Discrete–time delta hedging and the Black–Scholes model with transaction costs 231
Thus by (2.7) it follows:
= V − N(t )δ S
= V
t
(t +δt, S)(δ t ) +[V
S
(t +δ t, S) − N(t )] (δ S)
+
1
2
V
SS
(t +δt, S)(σ
2
S
2
Z
2
δt +2σμ S
2
Zδ t
3
2
)
+
1
6
V
SSS
(t +δt, S)σ
3
S
3
Z
3
δt
3
2
+ O(δt
2
). (2.13)
By choosing the number of shares in the following way
N(t ) = V
S
(t +δ t, S) (2.14)
the δS term can be eliminated completely and the risk in (2.13) can be reduced.
Hence we get
= V
t
(t +δt, S)(δ t ) +
1
2
V
SS
(t +δt, S)(σ
2
S
2
Z
2
δt +2σμ S
2
Zδ t
3
2
)
+
1
6
V
SSS
(t +δt, S)σ
3
S
3
Z
3
δt
3
2
+ O(δt
2
). (2.15)
By assumption the amount can be invested in a riskless asset with an interest
rate r compounded continuously. Then over the rehedging interval of length δt the
B = exp(rδt ) − = rδt + O(δt
2
). (2.16)
Let us deﬁne the hedging error H as the difference between the return to
the portfolio value and the return to the riskless value B over the rehedging
interval of length δt . By (2.13) and (2.14) we obtain
H = −B
= V
t
(t +δt, S)(δ t ) +
1
2
V
SS
(t +δt, S)
_
σ
2
S
2
Z
2
δt +2σμ S
2
Zδ t
3
2
_
+
1
6
V
SSS
(t +δt, S)σ
3
S
3
Z
3
δt
3
2
−rδt + O(δt
2
)
= V
t
(t +δt, S)(δ t ) +
1
2
V
SS
(t +δt, S)
_
σ
2
S
2
Z
2
δt +2σμ S
2
Zδ t
3
2
_
+
1
6
V
SSS
(t +δt, S)σ
3
S
3
Z
3
δt
3
2
−(V(t, S)− SV
S
(t +δt, S))rδt + O(δt
2
).
(2.17)
Moreover we have
(V(t, S) = V(t +δt, S)) − V
t
(t +δt, S)(δ t ) + O(δt
2
) (2.18)
232 M. Mastinšek
hence it follows:
H = −B = (1 +rδt )V
t
(t +δt, S)(δt )
+
1
2
V
SS
(t +δt, S)
_
σ
2
S
2
Z
2
δt +2σμS
2
Zδt
3
2
_
+
1
6
V
SSS
(t +δt, S)σ
3
S
3
Z
3
δt
3
2
−(V(t +δt, S)
−SV
S
(t +δt, S))rδt + O(δt
2
). (2.19)
Let us assume for a moment that there exists a solution V(t, S) of the following
partial differential equation
(1 +rδt )V
t
(t +δt, S) +
1
2
σ
2
S
2
V
SS
(t +δt, S)
−(V(t +δt, S) − SV
S
(t +δ t, S))r = 0 (2.20)
for t ∈ [0, T −δt ]. Then from (2.20) we obtain
H =
1
2
V
SS
(t +δt, S)
_
σ
2
S
2
(Z
2
−1)δt +2σμ S
2
Zδ t
3
2
_
+
1
6
V
SSS
(t +δt, S)σ
3
S
3
Z
3
δt
3
2
+ O(δt
2
). (2.21)
Taking expectations and noting that Z ∼ N(0,1) we get the mean
E(H) = O(δt
2
) (2.22)
and the variance
V(H) =
_
1
2
V
SS
(t +δt, S)σ
2
S
2
_
2
2δt
2
+ O(δt
3
) (2.23)
Therefore when the option value V(t, S) satisﬁes the following partial differential
equation:
V
t
(t +δt, S) +
1
2
σ
2
0
S
2
V
SS
(t +δt, S)
+r
0
SV
S
(t +δ t, S)) −r
0
V(t +δt, S) = 0, (2.24)
where σ
0
and r
0
are given by (2.6), then the hedging error has mean zero of order
O(δt
2
) and variance of order O(δt
2
). By a shift V
1
(t ) = V(t +δt) from (2.24) the
Black–Scholes–Merton equation for V
1
(t ) with expiry at t = T − δt is obtained.
Hence the BSM Eq. (2.5) with adjusted volatility σ
0
and interest rate r
0
follows.
Remark 2.2 We note that in V appearing in (2.8)–(2.12) the time derivative of
V
S
is implicitly considered by the relation:
V
S
(t +δ t, S) = V
S
(t, S) + V
St
(t, S)δt + O(δt
2
) (2.25)
Hence in (2.13) the term V
St
δt δS can be avoided and the obtained equation can be
transformed to the diffusion equation.
Discrete–time delta hedging and the Black–Scholes model with transaction costs 233
Remark 2.3 By Expansion (2.11) it readily follows that higher order derivatives
V
SS
and V
SSS
can be included into N(t) and hedging further improved. Since in
Proposition 2.1 the formof the Black–Scholes–Merton pde is preserved, the model
can be generalized to models with dividends and models with time dependent
volatility and interest rates.
By Proposition 2.1 it follows directly that in the discrete-time case the number
of shares held ﬁxed over the rebalancing interval depends on the length δt of the
interval. In addition by Remark 2.2, if δt is not small then the values of delta at time
t and t +δt may considerably differ, especially when the delta is more sensitive to
the change in time. If in (2.21) |Z| is near one, the gamma term is near zero and
so other terms of the hedging error prevail. In that case by (2.4) the hedging error
can be substantially reduced. Moreover, when options vega and rho are high, then
by (2.6) the adjustment of parameters with respect to δt can be considered.
3 Transaction costs
It is known that transaction costs can be included into the Black–Scholes–Merton
equation by considering appropriately adjusted volatilility (Leland 1985;
Avellaneda and Paras 1994; Toft 1996).
We denote here transaction costs by c
tr
. These costs depend on the volume of
transactions at rehedging and a constant percentage k.
Let us consider again the portfolio at time t consisting of one option long and
a short position in N(t ) units of stock S with the value = V − N(t )S.
Let k represent the round trip transaction costs, measured as a fraction of the
volume of transactions. Then the transactions costs of rehedging over the rehedging
interval of length δt are equal to
c
tr
=
k
2
S |N(t +δt ) − N(t )| , (3.1)
for the details (Leland 1985; Avellaneda and Paras 1994). If the discrete time trad-
ing is considered, then by (2.4) we have N(t ) = V
S
(t +δt, S)and the volume can
be approximated in the following way:
N(t +δt ) − N(t ) = V
S
(t +2δt, S +δS) − V
S
(t +δt, S)
= V
SS
(t +δt, S)δS + O(δt )
Let us assume
k < σ
_
πδt
2
(3.2)
Then the transaction costs are equal to
c
tr
=
k
2
S |V
SS
(t +δt, S)| |δS| + O
_
δt
3
2
_
=
k
2
σ S
2
|V
SS
(t +δt, S)| |Z|

δt + O
_
δt
3
2
_
. (3.3)
234 M. Mastinšek
In some cases it is possible to assume that S
2
V
SS
is of order O(δt
1
/
2
); for instance
see Leland (1985) for a European call option.
In the same way as in Sect. 2 [relations (2.13)–(2.15)] the change in value of
the portfolio can be studied. By (2.14) then it follows:
= V − N(t )δ S −c
tr
= V
t
(t +δt, S)(δ t )
+
1
2
V
SS
(t +δt, S)(σ
2
S
2
Z
2
δt −
k
2
σ S
2
|V
SS
(t +δt, S)| |Z|

δt +O
_
δt
3
2
_
(3.4)
By assumption that the amount can be invested in a riskless asset, it follows that
B = rδt + O(δt
2
) = (V(t, S) − V
S
(t +δt, S)S)rδt + O(δt
2
)
= (V(t +δt, S) − V
t
(t +δt, S)δt − V
S
(t +δt, S)S)rδt + O(δt
2
) (3.5)
In the same way as in (2.19) the hedging error can be obtained
H = −B
= (1 +rδt )V
t
(t +δt, S)(δ t ) +
1
2
V
SS
(t +δt, S)σ
2
S
2
Z
2
δt
−(V(t +δt, S) − SV
S
(t +δ t, S))r δt

k
2
σ S
2
|V
SS
(t +δt, S)| |Z|

δt + O
_
δt
3
2
_
(3.6)
We note that E(|Z|) =

2/π for Z ∼ N(0,1). Therefore by assuming that V(t, S)
satisﬁes the following partial differential equation:
(1 +rδt )V
t
(t +δt, S) +
1
2
σ
2
S
2
V
SS
(t +δt, S)

k
2
σ S
2
_
2
πδt
|V
SS
(t +δt, S)|
−(V(t +δt, S) − SV
S
(t +δ t, S))r = 0 (3.7)
it follows that the hedging error can be written in the following way:
H =
1
2
σ
2
S
2
V
SS
(t +δt, S)(Z
2
−1)δt

k
2
σ S
2
|.V
SS
(t +δt, S)|
_
|Z| −
_
2
π
_

δt + O
_
δt
3
2
_
(3.8)
Hence by assumption (3.2) we have
E(H) = O
_
δt
3
2
_
and
V(H) =
_
k
2
σ S
2
V
SS
(t +δt, S)
_
2
_
1 −
2
π
_
δt + O(δt
2
) (3.9)
Discrete–time delta hedging and the Black–Scholes model with transaction costs 235
By (2.6) and a transformation t +δt → t from Eq. (3.7) we get
V
t
(t, S) +
1
2
σ
2
0
S
2
V
SS
(t, S) −
k
2
σ
0
S
2
_
2
πδt
|V
SS
(t, S)|
−(V(t, S) − SV
S
(t, S))r
0
= 0 (3.10)
Eq. (3.10) is nonlinear. In the case where V
SS
(t, S) is of the same sign for all values
t and S the equation can be reduced to a linear equation. For instance a European
call or put option satisfy the requirement. Therefore the following result can be
obtained.
Proposition 3.1 Let C(t, S) be the value of the European call option, σ be the
annualized volatility, r the annual interest rate of a riskless asset and let the trad-
ing take place discretely with rebalancing intervals of length δt . If k satisﬁes (3.2)
and if the approximate number of shares N(t ) held short over the rebalancing
interval is equal to: N(t ) = C
S
(t +δ t, S),where C(t, S) satisﬁes the Black–Scho-
les–Merton equation
C
t
(t, S) +
1
2
σ
2
1
S
2
C
SS
(t, S) +r
1
SC
S
(t, S)) −r
1
C(t, S) = 0, (3.11)
With parameters
σ
2
1
=
σ
2
1 +rδt
_
1 −
k
σ
_
2
πδt
_
and r
1
=
r
1 +rδt
, (3.12)
then the mean and the variance of the hedging error are of order O(δt
3
/
2
)and
O(δt
2
) respectively.
Proof By relations (3.4)–(3.10) the proof can be given in the same way as that of
Proposition 2.1. We only note that the second derivative C
SS
of the solution of the
BSM equation is given by the Gaussian or normal density function and hence it is
a positive function. Thus the Eq. (3.11) is a direct consequence of Eq. (3.10).
For a short position in a call option and a long position in the shares we have
= −V + N(t )S. Thus in (3.4) and in subsequent equations all the signs with
the exception of the transaction costs term have to be changed. Therefore we con-
clude:
Corolarry 3.1 Let the portfolio consist of a short position in the European call
option and a long position in N(t) shares. If N(t ) = C
S
(t +δ t, S), where C(t, S)
satisﬁes the BSMequation (3.11) with parameter σ
1
given by : σ
2
1
= (σ
2
/1 +rδt )
_
1 +(k/σ)

2/πδt
_
, then the mean and the variance of the hedging error are of
order O(δt
3
/
2
)and O(δt
2
)respectively.
References
Avellaneda M, Paras A (1994) Dynamic hedging portfolios for derivative securities in the pres-
ence of large transaction costs. Appl Math Finance 1:165–194
Black F, Scholes M (1973) The pricing of options and corporate liabilities. J Polit Econ 81:637–
659
236 M. Mastinšek
Boyle P, Emanuel D (1980) Discretely adjusted option hedges. J Financ Econ. 8:259–282
Boyle P, Vorst T (1992) Option replication in discrete time with transaction costs. J Finance
47:271–293
Hoggard T, Whalley AE, Wilmott P (1994) Hedging option portfolios in the presence of trans-
action costs. Adv Fut Opt Res 7:21–35
Hull JC (1997) Option, futures & other derivatives. Prentice-Hall, New Jersey
Kocinski M (2004) Hedging of the European option in discrete time under proportional transac-
tion costs. Math Meth Oper Res 59:315–328
Korn R (2004) Realism and practicality of transaction cost approaches in continuous-time port-
folio optimisation: the scope of the Morton-Pliska approach. Math Meth Oper Res 60:165–174
Leland HE (1985) Option pricing and replication with transaction costs. J Finance 40:1283–1301
Mello AS, Neuhaus HJ (1998) A portfolio approach to risk reduction on discretely rebalanced
oprion hedges. Manag Sci 44(7):921–934
Merton RC (1973) Theory of rational option pricing. Bell J Econ Manag Sci 4:141–183
Toft KB (1996) On the mean-variance tradeoff in option replication with transactions costs. J
Finance Quant Analysis 31 (2):233–263
Reproducedwith permission of thecopyright owner. Further reproductionprohibited without permission.

the current value of delta gives an acceptable value such that the hedging error is small. depends on the length δt of the interval. due to transaction costs for instance. if the delta is more sensitive with respect to time. In continuous-time models the value of delta representing the number of shares held in the portfolio varies continuously with time. If V(t. Merton 1973]. Kocinski 2004]. However in presence of transaction costs more frequent trading may increase the accumulated costs considerably [Korn 2004. 3 the option valuation problem with transaction costs is considered and an appropriate equation describing the process is obtained. Suppose that the price of the underlying at time t is given by S(t) = S0 exp(νt + σ W (t)). [Black and Scholes 1973. S) the option value as a function of the underlying asset with price S and time t. The discrete-time adjusted Black–Scholes–Merton partial differential equation is derived and appropriate values for discrete-time hedging are given. In the papers of Leland and others. Toft 1996. S) of the current value of V. A speciﬁc example of a European call option is studied and a closed form representation of the discrete-time delta is given. the error will further increase. A closed form discrete-time delta dependent on the interval length δt can be obtained. When rebalancing intervals are relatively small and thus trading takes place very frequently. In this paper the time between rehedgings and the time sensitivity of delta is considered. when the rebalancing is not that frequent. then the expected hedging error may be relatively small.1) . then in general the hedging error will not be small. the number of shares kept constant is given by the Black–Scholes delta at time t regardless of the time between successive rehedgings and the time sensitivity of delta. then the delta value at time t is given by the partial derivative VS (t. (2. In practice where the trading takes place discretely in time. Short notes on further research and improvements of discrete hedging are given. Moreover. Mello and Neuhaus 1998]. In Sect.228 M. As an application the case of option valuation with transaction costs is treated and explicitly solved. In the case when δt is sufﬁciently small. For the analysis of the hedging error in the case where option values are described by the BSM-pde. S) is the option value at time t and S the price of the underlying asset. In this way the number of shares kept constant between successive rehedgings can be derived explicitly by the BSM pde adjusted to discrete-time trading.g. This means that reducing the risk and the hedging error is of main practical interest. which consider the option pricing problem with transaction costs by the Black–Scholes model. see e.g. However.. 2 Discrete-time Black–Scholes–Merton partial differential equation Let us denote by V = V (t. Mastinšek interval. The objective is to incorporate the time change of delta over the rebalancing interval into the model implicitly so that the resulting equation can be directly transformed to the BSM pde and solved as the diffusion equation. 2 the portfolio over the rebalancing interval is studied. the number of shares given by the delta is held constant over the rebalancing interval and thus the hedging error cannot be eliminated. The paper outline is as follows: in Sect. see e. [Boyle and Emanuel 1980.

1 Let V = V (t. (2. especially in the case where the delta is sensitive with respect to time. S +δS) where V(t. In practice where the trading takes place discretely in time. Let σ be the annualized volatility and r the annual interest rate of a riskless asset continuously compounded. Then the delta value at time t + δt is determined by the partial derivative VS (t +δt. S) + r0 SVS (t. The hedging error. 1) (Leland 1985. If the approximate number of shares N (t) held short over the rebalancing interval of length δt is equal to: N (t) = VS (t + δt. S) = 0 2 (2. hedging errors appear.3) In the continuous-time model where the hedging is instantanuous and the replication is perfect. Thus when continuous-time models are applied to discrete-time trading. where V is given by the BSM equation (Boyle and Emanuel 1980. In the continuation we will consider the case. t + δt). (2. Hull 1997) Let be the value of a portfolio at time t consisting of a long position in the option and a short position in N(t) units of shares with the price S = V − N (t)S. S) + σ0 S 2 VSS (t. S).4) . S) be the option value at time t and price S. t +δt) can be approximated by VS (t +δt. S) satisﬁes the Black–Scholes–Merton equation 1 2 Vt (t. S) − r0 V (t. Toft 1996). However. deﬁned as the difference between the return to the portfolio value and the return to the riskless asset over the rehedging interval.2). in short Z ∼ N (0. where V(t.2) where Z is normally distributed variable with mean zero and variance one. higher errors may occur (cf. when the rebalancing is not frequent.1 Suppose that after discrete hedging.S) is the solution of the Black–Scholes–Merton equation. For the mean-variance analysis of the error.5) (2. S) (the delta). σ the annualized volatility and μ = ν+(1/2)σ 2 the expected annual rate of return. the current value of the derivative gives an acceptable approximation for the discrete-time hedging with small error. Remark 2. depends on the length δt of the interval. We assume that hedging takes place at equidistant time points with rebalancing intervals of (equal) length δt. S) is the solution of the Black–Scholes– Merton equation. where hedging is in discrete time until expiry. S) are continuous functions on their respective domains. the number of shares given by the delta is held constant over the rebalancing interval (t. Moreover we let the trading be relatively frequent so that the interval length δt is relatively small.Discrete–time delta hedging and the Black–Scholes model with transaction costs 229 where W(t) is the Wiener process (Brownian motion). where V(t. S). Throughout we assume that partial derivatives of V(t. Then the change of S = S(t) over the small noninﬁnitesimal interval of length δt is approximately equal to √ δ S = S(t + δt) − S(t) = σ S Z δt + μ Sδt. In that case for example the constant value of delta over the rehedging interval (t. Remark 2. the number of shares N(t) is given by the current value of the derivative VS (t. for instance from a time point t + δt to expiry. This means when δt is sufﬁciently small. Then we have Proposition 2. continuous hedging is assumed.

S)(δ S)2 + VSSS (t + δt. Proof Let us consider the return to the portfolio over the period [t. 6 and I I = (V (t + δ t.7) as the number of shares N(t) is held ﬁxed during the time step δt. By (2. S)σ 3 S 3 Z 3 δt 2 + O(δt 2 ). t + δt] of length δt. S)) = I + I I where: I = (V (t + δ t. S)) 1 = VS (t + δ t. S) − V (t. S)(δ S)2 2 1 + VSSS (t + δ t. S)(σ S Z δt + μ Sδ t)3 + O(δt 2 ) (2. T − δt]. S)(δ t) + O(δt 2 ).10) (2. 6 (2. t ∈ [0.2) we get the approximation V = Vt (t + δt. S)(σ S Z δt + μ Sδ t)2 2 √ 1 + VSSS (t + δt.6) then the mean and the variance of the hedging error is of order O(δt 2 ). S) σ 2 S 2 Z 2 δt + 2σ μ S 2 Z δ t 2 2 3 1 + VSSS (t + δt. S) over the time interval [t.12) .8) (2. S)(δ S) 3 1 + VSS (t + δt. By assumption over the period of length δt the value of the portfolio changes by = V − N (t)δS (2. S)(δ S) √ 1 + VSS (t + δt. S + δ S) − V (t + δ t. S)) +(V (t + δ t. Mastinšek with parameters σ0 = σ √ 1 + r δt and r0 = r 1 + r δt . S)) = Vt (t + δt.230 M. S)(δ S) + VSS (t + δ t. S) = (V (t + δ t. We give the Taylor series expansion of the difference in the following way: V = V (t + δ t. t + δt]. S + δ S) − V (t + δ t. S)(δ S)3 + O(δt 2 ) 2 6 = Vt (t + δt. S)(δ t) + VS (t + δ t. (2. S)(δ t) + VS (t + δ t.9) (2. S) − V (t. S)(δ t) + VS (t + δ t. S)(δ S) 1 1 + VSS (t + δt. S + δ S) − V (t. First we consider the change V of the option value V(t.11) 6 hence V = Vt (t + δt. S)(δ S)3 + O(δt 2 ).

S))r δt + O(δt 2 ). S)(δ t) + VSS (t + δt. 6 (2.13) the δS term can be eliminated completely and the risk in (2. By (2.16) Let us deﬁne the hedging error H as the difference between the return to the portfolio value and the return to the riskless value B over the rehedging interval of length δt. S) − N (t)] (δ S) 3 1 + VSS (t + δt. S) = V (t + δt. Hence we get 3 1 = Vt (t + δt. S)σ 3 S 3 Z 3 δt 2 + O(δt 2 ).13) can be reduced.14) (2. S) (2. S) σ 2 S 2 Z 2 δt + 2σ μ S 2 Z δ t 2 2 3 1 3 3 3 2 + VSSS (t +δt. S)) − Vt (t + δt. S)(δ t) + VSS (t + δt. (2.Discrete–time delta hedging and the Black–Scholes model with transaction costs 231 Thus by (2. Then over the rehedging interval of length δt the return to the riskless investment is equal to B= exp(r δt) − = r δt + O(δt 2 ).14) we obtain H = − B 3 1 = Vt (t + δt. S)(σ 2 S 2 Z 2 δt + 2σ μ S 2 Z δ t 2 ) 2 3 1 (2. S)(δ t) + [VS (t + δ t. S)(σ 2 S 2 Z 2 δt + 2σ μ S 2 Z δ t 2 ) 2 3 1 + VSSS (t + δt.13) and (2. S)(δ t) + VSS (t + δt. S)− SVS (t + δt. S) σ 2 S 2 Z 2 δt + 2σ μ S 2 Z δ t 2 2 3 1 + VSSS (t + δt.18) . 6 By choosing the number of shares in the following way N (t) = VS (t + δ t. S)(δ t) + O(δt 2 ) (2. S)σ 3 S 3 Z 3 δt 2 − r δt + O(δt 2 ) 6 3 1 = Vt (t + δt.7) it follows: = V − N (t)δ S = Vt (t + δt. S)σ 3 S 3 Z 3 δt 2 + O(δt 2 ). S)σ S Z δt − (V (t. 6 By assumption the amount can be invested in a riskless asset with an interest rate r compounded continuously.17) Moreover we have (V (t.15) + VSSS (t + δt.

6 (2. S) + σ0 S 2 VSS (t + δt.2 We note that in V appearing in (2.8)–(2. (2. S)σ 2 S 2 2 2 (2. (2. S) = VS (t. S) 6 − SVS (t + δt. S)(δt) 3 1 + VSS (t + δt. S)) − r0 V (t + δt. S) σ 2 S 2 (Z 2 − 1)δt + 2σ μ S 2 Z δ t 2 2 3 1 + VSSS (t + δt.21) Taking expectations and noting that Z ∼ N (0. S) satisﬁes the following partial differential equation: 1 2 Vt (t + δt.232 M.13) the term VSt δtδS can be avoided and the obtained equation can be transformed to the diffusion equation. Then from (2. .6).1) we get the mean E( H ) = O(δt 2 ) and the variance V ( H) = 1 VSS (t + δt. S) of the following partial differential equation 1 (1 + r δt)Vt (t + δt. S))r = 0 for t ∈ [0. T − δt]. then the hedging error has mean zero of order O(δt 2 ) and variance of order O(δt 2 ). S)σ 3 S 3 Z 3 δt 2 + O(δt 2 ). S) + σ 2 S 2 VSS (t + δt. (2. S) = 0. S) − SVS (t + δ t.19) Let us assume for a moment that there exists a solution V(t. S) 2 + r0 SVS (t + δ t.20) we obtain H = 3 1 VSS (t + δt. S)σ 3 S 3 Z 3 δt 2 − (V (t + δt. S))r δt + O(δt 2 ). Remark 2. Hence the BSM Eq. By a shift V1 (t) = V (t + δt) from (2.24) where σ0 and r0 are given by (2.12) the time derivative of VS is implicitly considered by the relation: VS (t + δ t.20) (2.23) Therefore when the option value V(t.25) Hence in (2.5) with adjusted volatility σ0 and interest rate r0 readily follows. S) σ 2 S 2 Z 2 δt + 2σ μS 2 Z δt 2 2 3 1 + VSSS (t + δt.24) the Black–Scholes–Merton equation for V1 (t) with expiry at t = T − δt is obtained.22) 2δt 2 + O(δt 3 ) (2. Mastinšek hence it follows: H = − B = (1 + r δt)Vt (t + δt. S)δt + O(δt 2 ) (2. S) 2 −(V (t + δt. S) + VSt (t.

Avellaneda and Paras 1994). In that case by (2. Avellaneda and Paras 1994. especially when the delta is more sensitive to the change in time. Let k represent the round trip transaction costs. If the discrete time trading is considered. S + δS) − VS (t + δt. S)| |δS| + O δt 2 2 √ 3 k 2 = σ S |VSS (t + δt.2.4) the hedging error can be substantially reduced. S)δS + O(δt) Let us assume k<σ Then the transaction costs are equal to ctr = 3 k S |VSS (t + δt. If in (2.1 the form of the Black–Scholes–Merton pde is preserved. when options vega and rho are high.3) . then by (2. if δt is not small then the values of delta at time t and t + δt may considerably differ. measured as a fraction of the volume of transactions.3 By Expansion (2. Moreover. S)and the volume can be approximated in the following way: N (t + δt) − N (t) = VS (t + 2δt. S) = VSS (t + δt. 3 Transaction costs It is known that transaction costs can be included into the Black–Scholes–Merton equation by considering appropriately adjusted volatilility (Leland 1985.1 it follows directly that in the discrete-time case the number of shares held ﬁxed over the rebalancing interval depends on the length δt of the interval. 2 πδt 2 (3. We denote here transaction costs by ctr .6) the adjustment of parameters with respect to δt can be considered.21) |Z | is near one. 2 (3. S)| |Z | δt + O δt 2 . Since in Proposition 2. These costs depend on the volume of transactions at rehedging and a constant percentage k. Let us consider again the portfolio at time t consisting of one option long and a short position in N (t) units of stock S with the value = V − N (t)S. By Proposition 2. the gamma term is near zero and so other terms of the hedging error prevail. then by (2.4) we have N (t) = VS (t + δt.1) for the details (Leland 1985. Then the transactions costs of rehedging over the rehedging interval of length δt are equal to ctr = k S |N (t + δt) − N (t)| . Toft 1996). the model can be generalized to models with dividends and models with time dependent volatility and interest rates.Discrete–time delta hedging and the Black–Scholes model with transaction costs 233 Remark 2.2) (3. In addition by Remark 2.11) it readily follows that higher order derivatives VSS and VSSS can be included into N(t) and hedging further improved.

13)–(2. S)δt − VS (t + δt. S) − Vt (t + δt. 2 [relations (2. S)(σ 2 S 2 Z 2 δt − σ S 2 |VSS (t +δt. Mastinšek In some cases it is possible to assume that S 2 VSS is of order O(δt 1/ 2 ).4) By assumption that the amount can be invested in a riskless asset. S)| |Z | δt + O δt 2 2 2 (3.234 M. S)(δ t) + VSS (t + δt.8) Hence by assumption (3.7) 2 π √ 3 δt + O δt 2 (3. S)(δ t) √ 3 1 k + VSS (t +δt. for instance see Leland (1985) for a European call option. S) − SVS (t + δ t.19) the hedging error can be obtained H = − B 1 = (1 + r δt)Vt (t + δt. In the same way as in Sect. S) − SVS (t + δ t. S) 2 1− 2 π δt + O(δt 2 ) (3.VSS (t + δt. S) 2 k 2 |VSS (t + δt. S) − VS (t + δt. S)S)r δt + O(δt 2 ) = (V (t + δt.6) 2 √ We note that E(|Z |) = 2/π for Z ∼ N (0. S) + σ 2 S 2 VSS (t + δt. S)(Z 2 − 1)δt 2 k − σ S 2 |. Therefore by assuming that V(t.2) we have E( H ) = O δt 2 V ( H) = 3 and 2 k 2 σ S VSS (t + δt.9) . S)σ 2 S 2 Z 2 δt 2 −(V (t + δt. S))r = 0 it follows that the hedging error can be written in the following way: H = 1 2 2 σ S VSS (t + δt.1). S)| − σ S2 2 πδt − (V (t + δt.15)] the change in value of the portfolio can be studied. S)S)r δt + O(δt 2 ) (3. it follows that the return to the riskless investment is equal to B = r δt + O(δt 2 ) = (V (t.5) In the same way as in (2. S)| |Z | δt + O δt 2 (3. By (2.14) then it follows: = V − N (t)δ S − ctr = Vt (t + δt. S) satisﬁes the following partial differential equation: 1 (1 + r δt)Vt (t + δt. S)| |Z | − 2 (3. S))r δt √ 3 k − σ S 2 |VSS (t + δt.

10) Eq. Thus the Eq. We only note that the second derivative CSS of the solution of the BSM equation is given by the Gaussian or normal density function and hence it is a positive function.11) σ2 1 + r δt 1− k σ 2 πδt and r1 = r . (3. S) be the value of the European call option. (3. (3. r the annual interest rate of a riskless asset and let the trading take place discretely with rebalancing intervals of length δt.11) is a direct consequence of Eq.1. Therefore the following result can be obtained.10) is nonlinear.12) then the mean and the variance of the hedging error are of order O(δt 3/ 2 )and O(δt 2 ) respectively.2) and if the approximate number of shares N (t) held short over the rebalancing interval is equal to: N (t) = C S (t + δ t.4) and in subsequent equations all the signs with the exception of the transaction costs term have to be changed. where C(t. Proof By relations (3.10). σ be the annualized volatility. S) + σ0 S 2 VSS (t.7) we get 1 2 k 2 |VSS (t. For a short position in a call option and a long position in the shares we have = −V + N (t)S. S) is of the same sign for all values t and S the equation can be reduced to a linear equation. S))r0 = 0 (3. S) 2 satisﬁes the BSM equation (3. Therefore we conclude: Corolarry 3.where C(t. (3.4)–(3. S) − SVS (t. S) + σ1 S 2 C SS (t. In the case where VSS (t. References Avellaneda M.Discrete–time delta hedging and the Black–Scholes model with transaction costs 235 By (2.1 Let C(t. For instance a European call or put option satisfy the requirement. S) = 0.10) the proof can be given in the same way as that of Proposition 2. S) + r1 SC S (t. Proposition 3. Paras A (1994) Dynamic hedging portfolios for derivative securities in the presence of large transaction costs. S). S)| Vt (t. If N (t) = C S (t + δ t. S). Scholes M (1973) The pricing of options and corporate liabilities. Appl Math Finance 1:165–194 Black F. S) satisﬁes the Black–Scholes–Merton equation 1 2 Ct (t. J Polit Econ 81:637– 659 .6) and a transformation t + δt → t from Eq. 1 + r δt (3. 2 With parameters 2 σ1 = (3. S) − σ0 S 2 2 2 πδt −(V (t.11) with parameter σ 1 given by : σ1 = (σ 2 /1 + r δt) √ 1 + (k/σ ) 2/πδt . If k satisﬁes (3. S)) − r1 C(t.1 Let the portfolio consist of a short position in the European call option and a long position in N(t) shares. then the mean and the variance of the hedging error are of order O(δt 3/ 2 )and O(δt 2 )respectively. Thus in (3.

Bell J Econ Manag Sci 4:141–183 Toft KB (1996) On the mean-variance tradeoff in option replication with transactions costs. Prentice-Hall. J Finance Quant Analysis 31 (2):233–263 . Math Meth Oper Res 59:315–328 Korn R (2004) Realism and practicality of transaction cost approaches in continuous-time portfolio optimisation: the scope of the Morton-Pliska approach. futures & other derivatives. Manag Sci 44(7):921–934 Merton RC (1973) Theory of rational option pricing. Emanuel D (1980) Discretely adjusted option hedges. J Financ Econ. New Jersey Kocinski M (2004) Hedging of the European option in discrete time under proportional transaction costs. Neuhaus HJ (1998) A portfolio approach to risk reduction on discretely rebalanced oprion hedges.236 M. J Finance 40:1283–1301 Mello AS. Vorst T (1992) Option replication in discrete time with transaction costs. 8:259–282 Boyle P. Adv Fut Opt Res 7:21–35 Hull JC (1997) Option. Wilmott P (1994) Hedging option portfolios in the presence of transaction costs. Math Meth Oper Res 60:165–174 Leland HE (1985) Option pricing and replication with transaction costs. J Finance 47:271–293 Hoggard T. Mastinšek Boyle P. Whalley AE.

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