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Closed-Form Solutions for Option Hedging with

Market Impact

Tianhui Michael Li*

Princeton Bendheim Center for Finance and Operations Research and Financial Engineering

Robert Almgren

Quantitative Brokers, LLC and NYU Courant Institute

We present a highly-intuitive closed-form delta-hedging result for a large investor whose trades generate

adverse market impact. Unlike the complete-market or proportional-transaction-cost cases, the agent no

longer nds it tenable to be perfectly hedged or even within a xed distance of being hedged. Instead, he

may nd himself arbitrarily mishedged and optimally trades towards the classical Black-Scholes delta, with

trading intensity proportional to the degree of mishedge and inversely proportional to illiquidity. When

viewed in light of a recent result of Garleanu and Pedersen (2009), this suggests that delta-hedging can

be thought of as a Merton problem where the Merton-optimal portfolio is the Black-Scholes delta hedge.

Both the discrete-time and continuous-time problems are solved. We discuss a number of applications of our

result, including the implications of our model on intraday trading patterns and stock pinning at options

expiry. Finally, numerical simulations on TAQ data based on intraday hedging of call options suggest that

this strategy is able to signicantly reduce market impact cost with respect to Black-Scholes delta hedging.

1. Introduction

The solution to hedging an option in a complete market is well known (Black and Scholes 1973,

Merton 1973). However, the assumption of frictionless trading that underlies complete markets is far

from reality. Practioners who trade large positions are familiar with the concept of market impact

when trading in real markets with limited liquidity. For instance, a buyer who lifts orders from the

oer eats up liquidity and pushes his execution price ever higher. Liquidity of the underlying often

dries up during nancial crises such as the 1987 Crash, the LTCMs collapse, the recent subprime

debacle, or the London Whale scandal and this has only further heightened investor concerns about

liquidity.

We are interested in the optimal hedging of an option by a large risk-averse investor in an illiquid

market. There is a large literature on trading under transaction costs. Part of the literature is

interested in super-replication (Cetin, Soner, and Touzi 2010, Soner, Shreve, and Cvitanic 1995).

Our paper relaxes this requirement by having a nite penalty for being mishedged. Our paper is

more closely linked to these using a utility-based framework (Cvitanic and Wang 2001, Davis and

Norman 1990, Hodges and Neuberger 1989, Janecek and Shreve 2004, Leland 1985, Shreve and

Soner 1994).

Trading frictions have been modeled via various mechanisms. One strand of the literature is cen-

tered around illiquidity (Cetin, Jarrow, and Protter 2004). These authors hypothesize a stochastic

supply curve whose steepness coincides with illiquidity. Similar work was done by Bank and Baum

(2004). The major drawback of both their theories is that liquidity costs can be completely avoided

if trades are nite-variation. Hence, the cost of replicating an option is asymptotically zero as the

writer can take nite-variation approximations to the classical Black-Scholes -hedging technique.

* This research is based upon work supported by the National Science Foundation Graduate Research Fellowship

under Grant No. DGE-0646086 and the Fannie and John Hertz Foundation Graduate Fellowship. The author would

like to thank both organizations for their generous support.

1

Author: Option Hedging with Market Impact

2 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

To get around this problem, Cetin, Jarrow, Protter, and Warachka (2006) impose an articial

constraint on the minimum time between discrete trades.

Another strand of the literature models trading frictions as a cost proportional to trade size,

typically interpreted as arising from the bid-ask spread. Mathematically, these problems exhibit

a scaling which allows the authors to simplify their formulas. This branch of the literature uses

singular control and the optimal solution is typically in the form of a tracking band. As the portfolio

exits this band, the trader makes singular corrections to his holdings to keep it strictly within the

limits of the band (Cvitanic 1999, Cvitanic and Karatzas 1996). This is analogous to the results of

Davis and Norman (1990), Shreve and Soner (1994) for the Merton Problem. Typically, there is no

analytic form for these no-trade regions and much work has been done on their numerics (Clewlow

and Hodges 1997, Davis, Panas, and Zariphopoulou 1993) or asymptotics (Soner and Barles 1998,

Whalley and Wilmott 1997).

Yet another strand of the literature models the full order book. Alfonsi and Schied (2009),

Alfonsi, Fruth, and Schied (2007), Predoiu, Shaikhet, and Shreve (2010) model a resilient order

book where levels gradually replenish after large trades. They generally derive optimal strategies

in which the broker makes large block trades at the beginning and end of the trading period with

many small trades in between. These models often allow for general order book shape and are

mathematically rather challenging to work with.

The nal strand of related literature focuses on modeling eective market impact. Rather than

dwelling on the the details of microstructure, it models eective microstructure. The literature

began with Bertsimas and Lo (1998) and Almgren and Chriss (1999) who decompose price impact

in terms of both temporary and permanent price impact. The model was subsequently rened in

Obizhaeva and Wang (2005) by the addition of a transient price impact term. While earlier works

in the literature concentrated on the liquidation a xed number of shares in a nite period, these

impact models were applied to portfolio allocation (Garleanu and Pedersen 2009) and options

hedging (Rogers and Singh 2007), the liquidation of portfolios (Schied and Schoneborn 2007),

trading in both lit and dark venues (Kratz and Schoneborn 2010), and multiple-agent competitive

liquidation (Schoeneborn and Schied 2010).

In contrast to proportional-transaction-cost models, the source of incompleteness for our model

is price impact: the more aggressively one trades, the more impact is incurred proportionally.

The cost is no longer linear in the shares purchased and the problem no longer exhibits linear

scaling. We readily conceded that an ideal transaction cost model would naturally take into account

both bid-ask spread and market impact. However, such a model presents a dierent set of (very

intriguing) mathematical challenges that are beyond the scope of this paper. Nonetheless, we argue

that neglecting an explicit spread term is a more realistic model of the eective market impact

than including only the spread. The following cases serve to illustrate this point.

The spreads-only cost model assumes all orders are active (at the oer for purchases, at the

bid for sales). Most executions in US equities occur through electronic brokers who execute both

passively and aggressively. If the passive/active fraction is 50%, then the average execution is at

the mid price, i.e. the orders incur zero market impact (this assumes that all passive and active

orders execute at the top of the book). Most brokers are able to attain near-mid execution for

non-urgent orders.

For more urgent orders, the fraction of aggressive lls typically increases. For example, lls

that are 80% aggressive and 20% passive result in an eective market impact of 30% of the bid-ask

spread (again, assuming top-of-the-book execution). We can observe that the eective market-

impact is actually a smooth function of urgency and not realistically modeled by a xed, discrete

transactions cost as in the spread-only model.

For super-urgent orders, the top-of-the-book lls assumption is no longer realistic. A spread-

only model limits the market impact to the half-spread and is completely unable to account for

execution deeper into the book.

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 3

In order to realistically account for the last point in a microsturcture sensitive way, we would

need to directly model the order book and both active and passive orders. This is addressed in

another strand of the literature (Alfonsi and Schied (2009), Predoiu et al. (2010)) by explicitly

modeling the order book. However, doing so poses a dierent set of mathematical challenges that

are beyond the scope of this article. Our eective model is chosen to judiciously capture the

eective trading costs while minimizing mathematical fuss. Yet, we are still able to place this model

within a tractable framework to obtain a highly intuitive closed-form trading solution.

Despite this mathematical parsimony, our solution more realistically handles the case when the

portfolio is far from being hedged, for example due to a sudden movement in underlying price.

Under only proportional transaction costs, the optimal solution in this situation is to cross the

spread with market orders in order to re-enter the tracking band. In real markets, such an order

would likely eat several levels into the order-book, incurring signicant market-impact, not modeled

by the naive, proportional-transaction-costs model. Under our market-impact model, the optimal

solution in this situation is to trade aggressively towards being hedged, in a way that takes into

account both available liquidity and the degree of the mishedge. Our trading strategy is much

smootherindeed, we are approximating the impact-free Black-Scholes Delta, an innite variation

process, with trading positions that are dierentiable. A comparison is given in Figure 1 to illustrate

the point.

Figure 1 Comparison of the proportional-transaction-cost fxied-tracking-band strategy (top) and our dynamic

strategy (bottom). In the former, our (green) trading position changes only when the (blue) target leaves

the (gray) trading-band. In the latter, our (green) trading position smoothly adjusts to the same (blue)

target. Compare the smooth trading ow and position of the latter strategy to the abrupt trading of

the former.

We separate market impact into temporary and permanent impact terms following the framework

developed by Almgren and Chriss (2001). The temporary impact aects only the execution price

P

t

Author: Option Hedging with Market Impact

4 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

but has no eect on the fair value or fundamental price P

t

. In contrast, the permanent impact

directly aects P

t

while having no direct eect on the execution price

P

t

. Thus we can think of

the temporary impact as connected to the liquidity cost faced by the agent while the permanent

impact as linked to information transmitted to the market by the agents trades (see, for example,

Back (1992), Kyle (1985)).

Previous work involving the Almgren-Chriss model has involved trading in the presence of Dark

Pools (Kratz and Schoneborn 2010), portfolio liquidation (Schied and Schoneborn 2007), and com-

petitive liquidation (Schoeneborn and Schied 2010). Hernandez-Del-Valle and Pacheco-Gonzalez

(2009) extends the work to Geometric Brownian Motion and Horst and Naujokat (2008) extends

it to derivative valuation. Rogers and Singh (2007) also examine the delta hedging problem but for

agents with dierent risk preferences and were only able to obtain analytic expressions asymptot-

ically. Our work diers from theirs in that we derive closed-form expressions by using simpler risk

preferences. The paper most closely related to ours is Garleanu and Pedersen (2009). They solve

the innite-horizon Merton Problem under only temporary market-impact assumptions. As in

our setup, they use a linear-quadratic objective rather than the traditional expected utility setup

of the classical Merton Problem. They nd that trading intensity at time t (Proposition 5) is given

by

t

=h

_

X

t

target

t

_

1/

where X

t

is the number of shares, is an urgency parameter with units of inverse time, h >0 is

a dimensionless constant of proportionality related to the convexity of the continuation value, and

the target portfolio target

t

is related to the frictionless Merton-optimal portfolio. That is, with

market-impact costs, it is no longer optimal to hold the instantaneous Merton-optimal portfolio but

instead, the agent trades towards a new target portfolio (which is a new Merton-optimal portfolio).

The intensity of trading

t

is proportional to the distance between the current holdings and target

(X

t

target

t

) and is inversely proportional to the square-root of the illiquidity parameter .

We use an analogous nite-horizon setup on [0, T] with both temporary and permanent impact

and obtain that the trading intensity is

t

=h((T t))

_

X

t

target

t

_

where the target portfolio target

t

is now related to the frictionless Black-Scholes delta-hedge and

h() is a positive dimensionless function, which comes from the nite-horizon nature of the setup

(compare to (15) with =0 so K =1). Hence, as in Garleanu and Pedersen (2009), an agent facing

market illiquidity no longer maintains the zero-liquidity-cost optimal portfolio but instead trades

towards a new target to correct this mishedging. Furthermore, also as in Garleanu and Pedersen

(2009), the agents trading intensity

t

is proportional to the dierence between his current holdings

and the optimal no market-impact portfolio (X

t

target

t

) and inversely related to the market-

impact cost . If the option as well-approximated by having a constant gamma, we nd that target

t

is actually the Black-Scholes hedge (Theorem 1). This similarity to Garleanu and Pedersen (2009)

suggests that we can think of delta-hedging in an illiquid market as a Merton optimal investment

problem where the Merton portfolio is the Black-Scholes hedge portfolio. For more general options,

the target target

t

has an extra term accounting for the non-zero third derivative with respect to

spot of the Black-Scholes option price (Theorem 2).

The subsequent sections are as follows. We motivate our assumptions and formally set up the

problem in Section 2. Closed-form solutions for two general cases are presented in Section 3. In

Section 4, we give a number of applications and implications of our result. In Section 5, we give

a discrete-time formulation of the problem. This is necessary for performing discretized numerical

simulations on TAQ data. The discrete-time solution is used in the hedging simulation in Section 6.

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 5

2. Problem Setup

In this section, we rst give a heuristic justication for our objective (6). The resulting optimal

policy for this objective is then rigorously proved in Section 3. We give the market impact model,

our model for a European option, and our formal objective in the next three subsections.

2.1. Market Impact Model

Let (, T, P) be a complete probability space with T

t

being the ltration generated by W

t

. Consider

the trading model

X

t

=X

0

+

_

t

0

u

du

where X

t

is the number of shares held by the agent and

t

is the intensity of trading. The funda-

mental price is given by

P

t

=P

0

+

_

X

t

X

0

_

+W

t

(1)

where >0 is the coecient of permanent impact, >0 is the absolute volatility of the fair value,

and W

t

is a standard one-dimensional Brownian Motion. Using a linear Brownian Motion rather

than a geometric one is appropriate over the short time horizons considered in the paper and leads

to dramatic simplications in our result. Throughout this paper we neglect interests rates, which

is appropriate for the short time-periods under consideration.

To model temporary impact, we assume that the

t

th share (at time instant t) will cost a linear

premium

t

over the fair value

P

t

(

t

) P

t

=

t

where > 0 is the market impact parameter. Therefore, the total temporary impact (rate) of

buying

t

shares is

_

t

0

[

P

t

() P

t

]d =

_

t

0

d =

2

t

2

. (2)

We can think of temporary impact as coming from a limit-order book with constant depth 1/

and instant resilience (see, for example, Alfonsi and Schied (2009), Predoiu et al. (2010)). In such

a model, purchasing

t

shares would consume all the shares priced from P

t

to P

t

+

t

on the book,

thus pushing the execution cost of the last share up by

t

. The limit orders that were eaten up

are replaced immediately after execution. Thus our temporary impact coecient is related to

the corresponding term in Almgren and Chriss (2001) by =2.

2.2. European Option

We think of hedging a European contingent claim over a nite time horizon [0, T]. For a hypothetical

small trader whose execution has no price-impact and trades in a complete market, the value of

the options price g

_

t, P

t

_

is a function of the time t and the price P

t

of the underlying asset,

g : [0, T] RR.

Hence, the agents total portfolio value at time t is given by X

t

P

t

+g(t, P

t

). We assume the price

at t =T is given by g

0

: RR and the value for t [0, T) is prescribed by Feynman-Kac to be the

solution of the PDE

g(t, p) +

2

2

g

0

. (3)

Here g represents derivatives with respect to t and g

and g

p. We can view this as the Black-Scholes option-pricing PDE for the arithmetic Brownian Motion

Author: Option Hedging with Market Impact

6 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

P

t

and zero interest rates so that g has the interpretation of the option price in the corresponding

(no impact-cost) complete-market. For notational simplicity, we dene

(t, p) =g

(t, p)

to be the gamma of the option.

For a large trader who does face market-impact, the terminal wealth (or revenue) R

T

is the sum

of the options value, the stocks value, and the cost of acquiring the position,

R

T

= g(T, P

T

)

. .

T option value

+ X

T

P

T

. .

T stock value

_

T

0

_

t

0

P

t

()d

. .

acquisition cost

dt . (4)

Using integration by parts, the stock dynamics (1), the total temporary impact (2), and Feynman-

Kac (3), we may rewrite the terminal wealth as

R

T

=R

0

+

_

T

0

_

X

t

+g

(t, P

t

)

dP

t

2

_

T

0

2

t

dt ,

where

R

0

=g(0, P

0

) +X

0

P

0

.

It is now convenient to introduce the variable

Y

t

=X

t

+g

(t, P

t

)

with the interpretation as the portolios net delta exposure. This variable replaces net shares

held X

t

as a more relavent variable. Y

t

also has the interpretation of distance from being delta-

hedged as the ideal net delta-exposure is 0. Hence, we may decompose our wealth process into

three intuitive parts

R

T

=R

0

+

_

T

0

Y

u

dW

u

. .

Intraperiod

Fluctuation

+ Y

u

u

du

. .

Permanent

Impact

2

u

du

. .

Temporary

Impact

. (5)

If we interpret the interval [0, T] as the trading day, we have the wealth R

T

as the sum of the

uctuation during the trading day and the liquidity cost from permanent and temporary impacts.

Finally, we make the assumption

Assumption 1. Let g(t, p) have a gamma (t, p) that is bounded everywhere and Lipschitz in p

with a Lipschitz constant that is independent of t.

The above assumption holds, e.g., for the Delta and Gamma of calls and puts except at expiry and

so this formula will be valid for hedging except on the expiration day of the option. The case of

hedging at expiry is well-known for being dicult because of the divergence in Gamma and these

complications are beyond the scope of this paper.

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 7

2.3. Objective

Assumption 2. Assume and P

T

are L

2

random variables satisfying

1. the conditional distribution P[ [ T

T

] depends only on P

T

.

2. the conditional distribution P[P

T

[ T

T

] is independent of T

T

and has mean zero.

We dene our linear-quadratic objective to be

inf

E

_

2

(Y

T

P

T

)

2

. .

Terminal

Mishedging

+

_

T

0

2

2

Y

2

u

. .

Running

Mishedging

Y

u

u

. .

Permanent

Impact

+

2

2

u

..

Temporary

Impact

du

_

, (6)

where and P are to be dened later and the control set is given by

:=

_

predictable : E

_

T

0

2

s

ds < and

t

C(1 +[Y

t

[) a.s. for all t

_

.

This objective is standard in the literature and can be thought of as a nite-horizon adaptation

of Garleanu and Pedersen (2009). The relationship to utility optimization in the portfolio theory

literature is well-known and given in Fabozzi (2007, Chapter 2). The rst term in (6) gives a

terminal (time t = T) penalty for being mishedged. We allow this terminal penalty to be quite

exible so that it can accommodate multiple interpretations (through multiple intepretations of

and P: see Examples 1, 2, and 3). The running terms penalize for intraperiod mishedging

uctuations, and permanent and temporary impact. Equation (6) has a natural interpretation

of balancing the temporary and permanent liquidity costs with the penalty for variance of the

intraperiod and terminal mishedging errors.

The state variables have dynamics

dP

t

=

t

dt +dW

t

(7)

dY

t

=(1 +(t, P

t

))

t

dt +(t, P

t

)dW

t

. (8)

(Recall that is the gamma of the option). It is easy to see that P

t

is a continuous semimartingale

and hence predictable. We see from (1) that since is bounded that Y

t

is well-dened for all

. We see from (7) that every share purchased

t

pushes P

t

up by because of the permanent

impact. We also see from (8) that every share purchased

t

increases his net delta position Y

t

by

1+(t, P

t

): 1 for the increase in the stock position and (t, P

t

) for the permanent impacts eect

on the options delta.

Example 1. We could choose to interpret T as the maturity of the option. In this case, the

mishedging penalty is proportional to the time to maturity (i.e. the time remaining to potentially

accumulate mishedging). Hence, one might choose to not include a terminal term (P

T

= 0 and

=0) and no additional penalty is incurred for being mishedged at maturity

E

_

2

(Y

T

P

T

)

2

_

=0.

However, the individual trader may choose to incorporate a penalty because he nds it too risky

to be too mishedged even at expiry (see Remark 1).

Example 2. For general intraday trading, T would represent the close of trading. However, there

is an unhedgable potential overnight jump and trading does not resume until the next morning.

Therefore, we might choose to benchmark the objective to the opening of trade the next morning.

The choice of benchmarking to the morning is natural because the objective can be reset for the

Author: Option Hedging with Market Impact

8 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

next trading day. (Of course, the agent may choose to not incorporate a terminal penalty, even on

the day of the options maturity, as in Example 1).

For practical applications, adding a terminal mishedging penalty is more realistic. Without one,

the agents incentive to be hedged would (unrealistically) vanish as he approaches the closing bell.

This extra penalty reects the need to be well-hedged for the overnight jump, during which, he is

unable to trade.

To make this more precise, let T

T, and let

T = T

trade but the underlying price continues to evolve. From (4), we obtain

R

T

=g(T

, P

T

) +X

T

P

T

_

T

0

_

t

0

P

t

()ddt

=R

T

+g(T

, P

T

) g(T, P

T

) +X

T

(P

T

P

T

)

=R

T

+

_

T

T

[g

(t, P

t

) g

(T, P

T

)] dP

t

+Y

T

(P

T

P

T

) .

Then we can set the terms in the terminal penalty to

=

_

T

T

[g

(t, P

t

) g

(T, P

T

)] dP

t

P

T

=P

T

P

T

.

and the terminal penalty reduces to the quadratic (in Y

T

)

E

_

2

(Y

T

P

T

)

2

_

=

2

E

_

2

T

Y

2

T

2E[P

T

[ T

T

] Y

T

+E

_

2

[ T

T

_

where

2

T

=

2

T. Observe that the distribution of does not depend on P

T

and so satises

Assumption 2.

Example 3. One highly illustrative subcase of Example 2 is when we can approximate the option

as having a constant gamma, i.e.

g

(t, P

t

) g

(t, P

0

) +(P

t

P

0

) with R constant .

In other words, we assume (t, p) . Under this assumption, the terms in the terminal penalty

simplify down to

=

_

T

T

(P

t

P

T

) dP

t

P

T

=P

T

P

T

.

and so we can use ItoCalculus to derive

E[P

T

[ P

T

=p] =E

_

_

T

T

g

(u, P

u

) g

(T, P

T

) du [ P

T

=p

_

=0

(see Subsection 3.3 for the full calculation). Following directly from Example 2, the terminal objec-

tive would be

E

_

2

(Y

T

P

T

)

2

_

=

2

E

_

2

T

Y

2

T

+

2

.

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 9

3. Continuous-time Solution

Let J(t, p, y) be a C

1,2,2

([0, T] RR) function. Then from the Martingale Principle of Optimal

Control, we have the HJB equation is

0 =inf

2

2

y

2

y +

2

2

+

J +(1 +)

y

J +

p

J

+

2

p

J +

()

2

2

2

y

J +

2

2

2

p

J

=

1

2

[ (y

p

J) (1 +)

y

J]

2

+

2

2

y

2

+

J

+

2

p

J +

()

2

2

2

y

J +

2

2

2

p

J . (9)

We will not solve the equation in full generality but will stick to two major sub-cases. For these, it

suces to to make the Ansatz,

J(t, p, y) =

A

2

(T t)

2

y

2

+A

1

(T t, p)y +A

0

(T t, p) . (10)

We will later verify that this Ansatz holds in the proofs of Theorem 1 and Theorem 2. Observe

that A

2

has no dependence on p. This requires Assumption 2 and will be key to our decomposition.

Then the equation breaks up into the following three equations

A

2

=

2

[(1 A

1

) (1 +)A

2

]

2

(11a)

A

1

=

2

2

A

1

+

1

[(1 A

1

) (1 +)A

2

] [A

0

+(1 +)A

1

] (11b)

A

0

=

1

2

[A

0

+(1 +)A

1

]

2

+A

2

+

2

2

_

2

A

2

+A

. (11c)

(Here A

and

A denote the derivative with respect to p and t, respectively). Observe that the

equation for

A

2

(11a) cannot hold in general: A

2

does not have a dependence on p but A

1

does.

The equation will nonetheless hold in the two cases of interest. These equations are subject to the

boundary conditions

A

2

(0) =E

_

P

2

T

A

1

(0, p) =

2

E[P

T

[ P

T

=p]

A

0

(0, p) =

2

E

_

2

[ P

T

=p

.

The trading strategy is then

t

=

Y

t

(1 +(t, P

t

)) (A

2

(T t)Y

t

+A

1

(T t, P

t

)) (A

1

(T t, P

t

)Y

t

+A

0

(T t, P

t

))

. (12)

Hence, the optimal policy comes from solving for A

1

and A

2

. However, they exhibit closed-form

solutions in two important broad cases. Before we move on to these two cases, we rst dene

K =1 + =

_

d =

[K[

2

T

K

_

. (13)

Author: Option Hedging with Market Impact

10 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

3.1. Constant Gamma Approximation

On short time scales, we can safely assume that the option has a constant gamma. The approx-

imation says that for small intraperiod uctuations of P

t

P

0

, the options delta varies linearly

with the stock price. We make the the same approximation as in Example 3

g

(t, P

t

) g

(t, P

0

) +(P

t

P

0

) with R constant . (14)

As in Example 3, the terminal penalty will be

E

_

2

(Y

T

P

T

)

2

_

=

2

E

_

2

T

Y

2

T

+

2

T

. Furthermore, the dynamics of (8) are now independent of P

t

,

dP

t

=

t

dt +dW

t

dY

t

=(1 +)

t

dt +dW

t

where is now a constant. The assumption considerably simplies the problem by dropping the

dependence on the state variable P

t

and eliminating the function A

1

.

In this subsection, we will make the additional assumption

Assumption 3. Assume that either

1. d 1 holds or

2. d <1 and [K[T +arctanh(d) 0.

Theorem 1. Let Assumption 3 hold. Then the optimal trading intensity is given by

t

=h(K(T t))Y

t

(15)

where the function h is dened by

h(x) =

_

_

tanh

_

x+arctanh(d)

_

[d[ <1

1 d =1

coth

_

x+arccoth(d)

_

[d[ >1.

(16)

Under the optimal trading strategy, Y

T

,= 0 a.s. Indeed, P[[Y

T

[ > M] > 0 for all M > 0. That is,

because of the market-impact costs, the position is not perfectly delta hedged, even at the terminal

time and there is a chance (albeit small) that Y

T

is far away from 0.

Proof of Theorem 1 The Martingale Principle of Optimal Control tells us that

M

t

=

_

t

0

2

Y

2

u

Y

u

u

+

2

2

u

du+J(t, Y

t

)

is a submartingale for all

t

and a martingale under the optimal control. The HJB equation (9)

simplies to

0 =

2

2

y

2

+

J(t, y) +

()

2

2

J

(t, y)

1

2

_

y KJ

(t, y)

_

2

(17)

(t, y) =

1

(y KJ

wehre J

and J

J(t, y) =A

2

(T t)

y

2

2

+A

0

(T t) .

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 11

and (11a) and (11c) simplify to

A

2

=

2

( KA

2

)

2

,

A

0

=

()

2

2

A

2

.

We can see that

A

2

is a parabola opening downward in A

2

with vertex at the point (

K

,

2

) and

left and right critical points are A

2

and A

+

2

, respectively where

A

2

=

K

[K[

.

If A

2

(0) =

2

T

(A

2

, A

+

2

) then

A

2

(T t) >0 and so A

2

(T t) A

+

2

as T t . This corresponds

to the case when 1 <d <1 where the solution is given by

A

2

(T t) =

K

+

[K[

tanh([K[(T t) +arctanh(d))

A

0

(T t) =

()

2

2K

_

(T t) +

K

_

log cosh

_

[K[(T t) +arctanh(d)

_

+

1

2

log(1 d

2

)

_

.

(19)

Similarly, if A

2

(0) =

2

T

_

A

2

, A

+

2

_

then A

2

is xed at the critical point. This corresponds to the

case [d[ =1 and the solution is given by

A

2

(T t) =

K

+

d

[K[

=

2

T

A

0

(T t) =

2

2

2

2

T

(T t) .

(20)

Finally, if A

2

(0) > A

+

2

then

A

2

(T t) < 0 and so A

2

A

+

2

. This corresponds to the case d > 1

where the solution is given by

A

2

(T t) =

K

+

[K[

coth([K[(T t) +arccoth(d))

A

0

(T t) =

()

2

2K

_

(T t) +

K

_

log sinh

_

[K[(T t) +arccoth(d)

_

+

1

2

log(d

2

1)

_

.

(21)

These three cases cover case 1 of Assumption 3. Under case 2 of Assumption 3, equation (21) also

holds and A

2

(T t) is well-dened for t [0, T] since [K[(T t) +arccoth(d) 0 for all t [0, T].

Thus we have a solution J to the HJB equation (18) and we see that M

t

has non-negative drift

for all and is a local martingale for the optimal given in (15). To conclude the proof, we need to

show that M

t

is a submartingale for all and a martingale for the optimal . Thus, it suces

to show E[M]

T

< for all . Observe that the function A

2

(t) is uniformly bounded by some

C >0 independent of t [0, T] so that

E[M]

T

=E

_

T

0

(t, Y

t

)

2

dt

C

2

E

_

T

0

[Y

t

[

2

dt . (22)

Author: Option Hedging with Market Impact

12 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

Itos Lemma gives us

EY

2

t

=Y

2

0

+E

__

t

0

2Y

s

dY

s

+d[Y ]

s

_

=Y

2

0

+E

__

t

0

C

s

Y

s

+

2

2

ds

_

Y

2

0

+E

__

t

0

C

[Y

s

[

2

+

2

2

ds

_

for some C

, C

yields E[M]

T

< and we have (15) is the optimal policy.

The second part also follows from the fact that Y

T

is given by a linear SDE. Its solution

Y

t

=e

t

0

Kh(K(Ts)) ds

_

Y

0

+

_

t

0

e

s

0

Kh(K(Tu)) du

dW

s

_

has a density that is non-singular with respect to the Lebesgue measure on R as h is bounded.

In Almgren and Chriss (2001) is an urgency parameter which dictates the speed of liquidation:

the higher the faster the initial liquidation. In Garleanu and Pedersen (2009), this term gives

the relative intensity of trading

1

, that is, the higher , the faster the agent trades towards the

Merton-optimal portfolio.

The agents trading target for shares X

t

is the Black-Scholes delta hedge,

target

t

=g

(t, P

t

) .

He constantly trades towards this target but is prevented from holding the exact Black-Scholes

delta hedge by the convex temporary impact stemming from limited liquidity. Hence, the trading

intensity

t

is proportional to the degree of mishedge Y

t

and the urgency parameter . There is

a greater penalty to being mishedged with higher underlying volatility and risk aversion so

these parameters increase urgency. Similarly, a more illiquid market (higher ) makes trading more

costly, which decreases trading intensity.

The solution falls into three cases depending on whether h(), the trading intensity proportion,

is decreasing, at, or increasing in time, i.e. whether the agent trades less intensely, is at, or more

intensely (respectively) towards the end of the trading period. This, in turn, depends on the value

of a constant d which gives the relative size of the overnight jump P

T

versus permanent impact

and noise dP

t

.

The interpretation of d is clearer when there is no permanent impact ( = 0) and we rst

handle this case. In this case, the cost of being mishedged comes purely from running and terminal

mishedging terms. Intraperiod trading can be thought of as primarily hedging out the intraperiod

uctuations dP

t

while trading near the end of the period is primarily for hedging the terminal

jump P

T

. When d <1, the majority of the uctuations occur during the day, and the solution is

marked by t h(K(T t)) decreasing as t approaches T. That is, the agent is more concerned

about hedging intraperiod uctuations dP

t

and relaxes hedging intensity to reduce hedging cost

as the end of the period approaches. This is the case in Example 1 where d =0. The second case

is when d =1 and hedging risk for the intraperiod and end-of-day are weighted equally. Then the

agents trading intensity is constant in time. The nal case is when d >1 and the terminal jump

is large compared to the daily uctuations. So the agent trades more intensely with time and

t h(K(T t)) increases towards d as t approaches T. This case could occur in Example 2.

1

The a/ in Proposition 5 of Garleanu and Pedersen (2009) is equivalent to h in our setup

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 13

Units of Fundamental Quantities

Y

t

sh 1/$ $/sh

2

P $/sh sec $/sh

2

sh

2

/$

sh/sec $/sh/

sec J $

Units of Derived Quantities

K 1 d 1 1/sec

Table 1 Units for constants: sh is a share, sec is a second, and $ is a dollar.

Remark 1. If we consider the case when [0, T] is the trading day, the last case (21) when d >1

is the most realistic. Options market-makers typically increase their hedging towards the close

of trading to minimize overnight exposure. The trader may choose a lower d as options expiry

approaches, selecting d = 0 on the day of options expiry. However, this strategy may be deemed

too risky and the trader may choose d >0 even at expiry to avoid the risk of being mishedged.

When there is permanent impact ( >0), the running penalty comes from two sources in (6), the

running mishedging term and the permanent impact. The running mishedging term is as above but

the permanent impact term is more subtle. If the trader is in a net long delta position, he sells the

position to remain hedged, incurring a capital loss from the downward pressure on his inventory.

A buy to hedge out a net short delta position incurs a similar loss and so the permanent impact

creates a cost for being mishedged in either direction. The terms for A

2

in (19), (20), and (21) have

an extra term which accounts for the permanent impact. The size of d balances the running costs

(both from running uctuations and the permanent impact eect) with the terminal cost of being

mishedged.

3.2. Comparative Statics

We give some comparative statics for our solution. The eect of the temporary impact term

is the easiest to understand. As the cost of hedging decreases, it becomes optimal to trade more

aggressively to minimize mishedging error (see Figure 2c). The eect of risk aversion is similar.

As increases, so does the penalty for being mishedged and there is a stronger incentive to trade

more aggressively (see Figure 2e). To understand the eect for intraperiod volatility , recall that

the agent is trying to hedge both intraperiod volatility (via intraperiod trading) and volatility

from the terminal jump

T

(via trading near the end). As intraperiod volatility increases while

the terminal jump size

T

remains constant, the agent optimally trades more aggressively initially

while still ending at the same trading intensity at time t =T (see Figure 2b). The eect of increasing

terminal jump volatility

T

while keeping intraperiod volatility constant is roughly the opposite

(see Figure 2f): it increases trading near t =T while trading during the rest of the period remains

relatively unaected. Note that with higher

T

, there is a need to trade slightly more intensely

even at the beginning of the period t =0 as this impacts the mishedging at the end of the period

t =T.

and the permanent impact have more complex eects, which are qualitatively similar to

each other. There are two competing eects at play, whose importance diers with the time to

maturity. Firstly, there is an adverse-impact eect stemming from the permanent impact. To

see this, let Y

t

<0 so the agent optimally wishes to purchase shares. This purchase will push up

each shares value by , hence resulting in a decrease of Y

t

<0 in the stock value of the agents

portfolio. In general, rebalancing under permanent impact always hurts his existing position, giving

the agent an incentive to trade less aggressively in the hope that subsequent price-uctuations will

automatically rehedge his portfolio. The second eect is dubbed the leverage-eect. With =0,

the purchase of a single share increases the traders net delta position Y by 1. However, if >0

Author: Option Hedging with Market Impact

14 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

(a) varying (b) varying

(c) varying (d) varying

(e) varying (f) varying T

Figure 2 Comparative statics of (KA2(T t) )/ as a function of t. Parameters (unless otherwise specied):

=5.0, =0.2, =0.2, =0.2, =2.0, T =0.4, T =1.0.

then his net delta position actually increases by K =1 + due to the permanent impacts eect

on the options price . When >0, the eect of a purchase on the portfolios net delta position

is leveraged by the permanent impact on the options delta. We can think of this as eectively

lowering the cost of trading, (i.e. lowering the cost of achieving a xed change in delta). Hence,

the agent optimally increases the intensity of trading. When <0, the eect of a sale or purchase

is diminished, if not reversed. We can think of this as reducing the eectiveness of trading on the

net delta position or increasing the cost of rebalancing. Either way, the agent optimally decreases

the intensity of trading.

The relative importance of the two eects can be seen in the expression

t

=

1

_

Y

t

KJ

(t, Y

t

)

.

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 15

The leverage-eect acts through KJ

t

. In Figure 2,

d >1 and the pressure to be hedged (KJ

the beginning of the period, the adverse impact is the overriding concern and trading intensity is

less aggressive with higher because of the adverse-impact eect (Figure 2d) Near the end, the

agent is more concerned about hedging the terminal jump. This combined with the ease of hedging

from the leverage eect acting through KJ

(t, Y

t

) implies the agent trades more aggressively with

higher near the end. The eect of is similar except that it only directly aects the leverage

eect. With higher , the increase in the leverage eect allows the agent to optimally trade more

aggressively, particularly near the end of the day (Figure 2a). However, like varying

T

, because

aects mishedging near the closing bell, it has an indirect eect on the trading intensity during

the middle of the day as well.

3.3. General Options, No Permanent Impact

We can relax the constant gamma assumption and allow for general options. However, to make the

solution tractable, we need to dispense with permanent impact ( =0). We are still able to obtain

a fairly explicit solution for the control in (12) through A

2

and A

1

. Recall that we have made

the assumptions Assumption 1 on our option.

Theorem 2. The optimal control is given by

t

=

A

2

(T t)Y

t

+A

1

(T t, P

t

)

(23)

with

A

2

(T t) =

_

_

tanh((T t) +arctanh(d)) d <1

2

T

d =1

coth((T t) +arccoth(d)) d >1

and

A

1

(T t, p) =

_

_

1

1 d

2

sech((T t) +arctanh(d)) E[F(p +B

Tt

)] d <1

exp

_

2

T

(T t)

_

E[F(p +B

Tt

)] d =1

1

d

2

1

csch((T t) +arccoth(d)) E[F(p +B

Tt

)] d >1

where we assume B is a new Brownian Motion, the constants and d are dened by

=

_

d =

2

T

=T

and the function F() is dened by

F(p) =

2

E

_

P

T

P

T

=p

_

.

Proof In this case, the equations (11) then reduce to

A

2

=

2

A

2

2

A

1

=

2

2

A

A

2

A

1

A

0

=

A

2

1

2

+

2

A

1

+

2

2

_

2

A

2

+A

.

Author: Option Hedging with Market Impact

16 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

The solution for A

2

then follows immediately. (Observe that the range of tanh includes (0, 1) and

the range of coth includes (1, )). Feynman Kac then gives us

A

1

(T t, p) =E

_

exp

_

_

T

t

A

2

(T s)

ds

_

F(p +B

Tt

)

_

(24)

where B is any Brownian Motion. We have by Assumption 1 that g

is bounded hence g

is

Lipschitz. Since we have

F(p) =

2

E[P

T

[ P

T

=p]

=

2

E

_

2

_

T

T

g

(u, P

u

) g

(T, P

T

) du [ P

T

=p

_

we can show that F is Lipschitz as well. Hence A

1

given by an expectation in (24) is well-dened.

Observe that

sech(arctanh(d)) =

1 d

2

d <1

csch(arccoth(d)) =

d

2

1 d >1

from which our expressions for A

1

then follow. Finally, since the PDE for A

0

is linear, it is straight-

forward to verify it exists and so we may dene J as in (10).

For the verication argument, dene

M

t

=

2

2

Y

2

u

Y

u

u

+

2

2

u

du+J(t, P

t

, Y

t

)

Since J solves the HJB equation (9), we have that M

t

has non-negative drift for all and zero

drift for the optimal policy given in (23). Again, we shall show that for all , the expected

quadratic variation E[M]

T

<. We have

E[M]

T

=E

_

T

0

A

2

(T t)Y

t

+A

1

(T t, P

t

)

2

dt

C

E

_

T

0

[1 +Y

t

+P

t

[

2

dt , (25)

where C

1

is bounded and A

2

is Lipschitz in p, we have for all

that

E

_

T

0

[1 +Y

t

+P

t

[

2

E[1 +Y

0

+P

0

[

2

+2E

_

T

0

(1 +Y

s

+P

s

) [1 + (1 +(s, P

s

))]

s

+

2

(1 +(s, P

s

))

2

ds

E[1 +Y

0

+P

0

[

2

+CE

_

T

0

[1 +Y

s

+P

s

[

2

ds (26)

by the denition of and the fact that (t, p) is bounded (1). A standard application of Gronwalls

Lemma yields E[M]

T

<.

The optimal control diers from the constant gamma case in that the target is no longer the

delta-neutral portfolio. There is a new term A

1

(T t, P

t

), which biases the target portfolio to

account for the third-derivative of the option price, or the delta of the gamma. If this quantity

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 17

vanishes, then F(p) vanishes and so does A

1

. To see this, consider the setup of Example 2 and

observe that by Itos Isometry that

F(p) =

2

E

_

2

_

T

T

g

(u, P

u

) g

(T, P

T

) du [ P

T

=p

_

.

F has an interpretation as the average change in delta of the option over the period T to T

. We

saw in Example 3 that F and hence A

1

vanish for options with constant gamma.

More generally, if the option has vanishing delta of gamma (that is, g

we have by Itos Lemma that

E[g

(t, P

t

) g

(T, P

T

)] =E

__

t

T

g

(u, P

u

)dW

u

+

1

2

g

(u, P

u

)

2

du

_

=0.

Hence, F and A

1

also vanish. For an option with positive delta of gamma (g

is delta-neutral at the close T will actually have a positive expected overnight delta exposure F.

He corrects for this by adding a negative bias to his trading target for shares X

t

is

target

t

=g

(t, P

t

)

A

1

(T t, P

t

)

A

2

(T t)

.

The eect is the opposite if g

1

increases as

t T (see Figure 3). This follows since the bias corrects for an overnight delta slippage and is less

relevant far away from the closing bell.

We plot the oset A

1

in Figure 3. Compared with Figure 3 we omit the plots for (as = 0)

and (as can only aect A

1

through a nonzero ). As expected, a higher reduces the tracking

bias A

1

as it increases the penalty for not being delta-hedged, although this dierence disappears

as t T (see Figure 3a.) Varying and have inverse eects: increasing is similar to increasing

(increasing the penalty for mishedging) while increasing has the inverse eect (increasing the

market impact costs). The results are plotted in Figure 3b and Figure 3c. Finally, increasing

T

also increases the running costs of being mishedged (it increases A

2

in Figure 2f). This in turn

decreases A

1

(see (24) and Figure 3d).

4. Asymptotics and Applications

4.1. Small Market-Impact Cost Limit

We are interested in the limit as both the temporary and permanent impacts vanish. For instance,

in the constant gamma case (Theorem 1) the trading intensity

t

is proportional to the distance

from being delta hedged Y

t

=X

t

+g

(t, P

t

) as given in

t

=coth

_

K(T t) +arccoth(d)

_

Y

t

.

We observe in Figure 2d that the prole of trading intensity attens as a function of time with

decreasing and from Figure 2c, we see that the trading intensity shifts upward with decreasing .

Hence, we observe the trading intensity both increasing and attening as market-impact decreases.

In the limit as 0 and 0, we have K 1, . If

T

> 0 then d as well. Therefore

A

2

(T t) and

t

/Y

t

and the process Y

t

is driven back to zero very quickly. That is,

the agent aggressively drives X

t

towards g

(t, P

t

). Hence, we recover the Black-Scholes equation in

the limit of vanishing transaction costs. Similarly, for general options and no permanent impact

(Theorem 2), we still have A

2

(T t) and A

1

(T t, p) 0 for all p and t < T and so again

t

/Y

t

. The following theorem makes this idea precise.

Author: Option Hedging with Market Impact

18 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

(a) varying (b) varying

(c) varying (d) varying T

Figure 3 Comparative statics of A1(T t) as a function of t. Parameters (unless otherwise specied): =0.2, =

0.2, =2.0, T =0.4, T =1.0. We normalize E[F(p +BTt)] to be 1.

Theorem 3. Assume that the assumptions of either Theorem 1 or Theorem 2 hold. In the limit

of vanishing market-impact costs, we recover the Black-Scholes delta hedge. That is |Y | 0 as

, 0 where | | is the L

2

(P)-norm and is the Lesbegue measure on [0, T].

Proof If we make the assumptions of Theorem 1, we have from (26) that

E

_

Y

2

t

_

Y

0

+

2

2

T

_

exp

_

_

t

0

Kcoth

_

K(T s) +arccoth(d)

_

ds

_

.

and the result then follows from noting that , K 1, and d in our limit. In the setup of

Theorem 2, we the result follows similarly by (26) and the fact that A

2

(T t) and A

1

(T t, p)

0 in the limit.

4.2. Small Intraperiod Mishedging Penalty Limit

We consider the case when the penalty for the terminal jump is large compared to the intraperiod

hedging penalty. Mathematically, this is the limit when 0 and and

T

are held constant.

The objective in this limit is given by

inf

E

_

2

T

2

Y

2

T

_

T

0

Y

u

u

+

2

2

u

du

_

(27)

where we have removed the intraperiod mishedging penalty. We include this result because (28)

clearly demonstrates the increasing nature of the functions

t

/Y

t

as t T in terms of algebraic,

rather than transcendental, functions.

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 19

Theorem 4. We assume that the option has constant gamma as in Theorem 1. Then for small

intraperiod mishedging, the optimal trading intensity

t

can be written as

t

=

d

1 +Kd(T t)

Y

t

. (28)

Proof If we make the Ansatz (10) then again A

1

= 0 and we separate the resulting HJB by

powers of y. This yields

(t, y) =

1

( KA

2

(T t))y

and

A

2

=

1

_

(1 +)A

2

2

A

2

(0) =

2

T

A

0

=

2

2

2

A

2

A

0

(0) =0.

By a similar argument as in Theorem 1, we obtain that

A

2

(T t) =

1

K

_

+

d

1 +dK(T t)

_

A

0

(T t) =

2

2

2K

_

(T t) +

K

log

_

1 +dK(T t)

_

_

.

The result then follows.

For a sense of how the execution of the policy in Theorem 4 compares to the full case in Theo-

rem 1, see Figure 4. Observe that without an intraperiod mishedging penalty, the trading intensity

ratio

t

/Y

t

(see (28)) is lower than with the intraperiod penalty (see (15)), especially during the

beginning of the period. The extra trading comes from hedging out uctuations during the period.

Intuitively, the optimal investor trades less aggressively when only faced with a terminal and no

running mishedging penalty. As in the d >1 case in Theorem 1, trading becomes more aggressive

towards the end of the period.

If we take the interpretation of [0, T] as the trading day, then this approximation is valid when

the the overnight jump is large compared to the daily uctuations. This may be the case in advance

of a major post closing-bell announcement.

Figure 4 Comparison of trading intensity with and without intraperiod mishedging penalty. The parameter values

are dened as in Figure 2

.

Author: Option Hedging with Market Impact

20 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

4.3. Restriction on the direction of trading

If executed through a broker, the delta-hedging problem is more challenging. Regulatory policy

mandates that brokers can only either buy or sell for any given client order. This is to prevent

market-manipulation and to protect clients from potentially unscrupulous dealers. We solve the

optimal delta-hedging problem under these constraints.

Without loss of generality, we impose a buy-only restriction on trading. That is, we add the

constraint

t

0 a.s. to the minimization of our objective (6),

inf

+

E

_

2

(Y

T

P

T

)

2

+

_

T

0

2

2

Y

2

u

Y

u

u

+

2

2

u

du

_

, (29)

where

+

= , 0 a.s.. While the problem is still Markovian, a closed-form solution is no-

longer readily available. We use a policy-improvement algorithm that assumes a Markovian optimal

policy

t

=(t, Y

t

) to solve this problem. As a check, the same policy-improvement code was used

to solve the Simplied Model in Section 4.2 and compared against the analytic solution found in

Section 4.2. It obtained continuation-value functions J accurate to within .1%.

A comparison of the restricted and unrestricted cases are plotted in Figure 5. Observe the

asymmetry in trading policy (t, y) in Figure 5c. For negative values of y, (t, y) is positive to

reduce the delta-hedging error, that is the agent still purchases stock as in the unrestricted case

(compare with Figure 5a). For positive values of y, an unrestricted agent would sell shares but a

restricted agent cannot do so, and the binding constraint forces to be zero (see Figure 5c). There

is a no-trade curve y(t) 0 such that the agent trades if and only if he his current net delta position

is below this level, i.e.

t

=0 when Y

t

y(t) and

t

>0 when Y

t

<y(t). This curve is marked in the

plot in Figure 5c. Observe that y(0) <0 and t y(t) is an increasing function. Hence, far from the

terminal time (t T), the agent does not purchase stocks even when he is net short delta. The

result is interpreted thus: a selling-restricted agent is hesitant to purchase stock only to see his

delta position become positive before T due to stock-price uctuations. However, y(T) =0 so this

eect disappears as t T: as the time remaining for Y

t

to uctuate above 0 runs out, the agents

rule becomes buy if I am net short delta.

In the restricted case, the asymmetry in execution strategy for translates into an asymmetry for

the value function J (compare the restricted case Figure 5d with the unrestricted one Figure 5b).

For negative values of Y

t

, J behaves similarly in both the selling-restricted and non-restricted cases

as the optimal strategies are similar. For positive values of Y

t

, J is signicantly higher in the

selling-restricted case as the control cannot be exercised to reduce the hedging error. The dierence

between the two cases represents the premium of being able to sell.

4.4. Stock Pinning

The increase in trading intensity for high gamma near the expiry is the mechanism behind stock

pinning. A put or call option that is about to expire with a large outstanding institutional interest

and with a stock price near a strike level can induce a so-called pinning eect whereby the stock

price at the close of trading on expiry is pinned to the strike level. Empirically, this manifests

itself in the observation that the distribution of end-of-day stock prices on these days deviates

substantially from the distribution of end-of-day stock price on any other days. That is, the stock

price clumps around the strike level at the close of such an option expiry (Avellaneda and Lipkin

2003).

A call or put option near expiry with the underlying prices near its strike exhibits a large positive

gamma. When institutional investors are net short gamma (perhaps because they collectively short

the put or call) option market makers are net long gamma. The market-makers will hedge their

position by buying stock as the price dips and selling it as the price increases, thus stabilizing

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 21

(a) Unrestricted (t, y) (b) Unrestricted J(t, y)

(c) Restricted (t, y) (d) Restricted J(t, y)

Figure 5 Plots of the continuation-value function J and the optimal policy for the unrestricted case (Figure 5b

and Figure 5a) and the case when trading is restricted to purchases 0 (Figure 5d and Figure 5c). In

the restricted case, we also plot the no-trade boundary in black, above which (t, y) =0 (see Figure 5c).

Parameters: =5., =.4, =.2, =.2, =2., T =.4, T =1.

the price. Then as Figure 2a shows, a large gamma implies the agent trades intensely as expiry

approaches and as his trades are stabilizing, the permanent impact pins the stock price at the

strike. Since the gamma peaks near expiry with the underlying price near the strike, the eect

manifests itself as pinning near the strike.

Our model provides some insight into this model. Observe that for a call option, the delta is

given by

C

(t, p) =E[1

P

T

>0

[ P

t

=p] =N

_

p

T t

_

and so the gamma is given by

C

(t, p) =

1

_

2

2

(T t)

exp

_

p

2

2

(T t)

_

. (30)

For small uctuations of p, the gamma appears to be at. Let g =NC where N is a large positive

number representing the number of call options held. We make the constant gamma assumptions

of Theorem 1, where now the gamma will be NC

Author: Option Hedging with Market Impact

22 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

It turns out that this assumption is valid for large N and moderately large values of T t. For

simplicity, we take d =1 so that

t

=Y

t

and we rewrite (7) and (8) as

dP

t

=

1

(dY

t

t

dt)

dY

t

=(1 +)Y

t

dt +dW

t

.

Hence, we have that the stationary distribution of Y

t

is

Y

t

A

_

0,

()

2

2(1 +)

_

.

That is, both

t

and Y

t

are distributed with standard deviation proportional to

N in the limit as

N . Hence, we have that the standard deviation of P

T

1/

N as N . In other words, if

P

0

starts close to the strike then P

t

will remain not deviate far and the price is pinned to the strike.

We can see from (30) that near the strike (p =0) the gamma of the call option is at in moneyness.

Hence, our constant gamma approximation is valid in the limit as N as the pinned stock only

sees a at gamma surface.

4.5. Intraday Trading Patterns

If we continue with the interpretation of the trading period as the trading day, we see that it is

consistent with the intraday trading pattern. The typical daily prole is U-shaped, with the most

intense trading occurring during the opening and close (see Figure 6a). Compare Figure 6a with

the graph of the average trading volume from delta hedging in Figure 6b as predicted by our model,

E[

t

[

with Y

0

N(0,

0

). The distributional assumption on Y

0

comes from the overnight uctuations

in the underlying aecting the delta of the option. The expression for E[

t

[ is given in (31). The

parameters for the plot are chosen to reect realistic values and are explained in Example 4.

We see that our model predicts a trading rate that is roughly 20% of the trading for (NYSE:BA).

More importantly, the trading volume prole roughly corresponds to the double-humped trading

pattern that is observed in the empirical data. Near the open, the high E[

t

[ comes from the

high initial variance in Y

t

as the trader trades down his net delta position from the previous

evenings jump. Near the close, the high E[

t

[ comes from the increase in h near t = T, which

represents aggressive trading in anticipation of the coming evenings overnight jump. Clearly the

intraday trading volume is determined by many additional factors. However, on stocks with a large

outstanding interest, Figure 6 illustrates how delta hedging may account for a signicant fraction

of the trading.

Example 4. We choose =.04 based on the corresponding value for Boeing (NYSE:BA) in Fig-

ure 2 (see the chart for units). We set

0

= (1.5

T

) with

T

from Figure 2. This corresponds

to the change in the options delta from an overnight jump in the stock of size 1.5

T

. If the book

were perfectly hedged the night before, we would see a jump of size

T

in the option value. The

factor 1.5 accounts for the book not being perfectly hedged at the close of the previous evening.

We set T =6.5 hours, the length of the trading day. =10

4

corresponds to a temporary impact

of 10 cents for trading 20% of ADV or 32 shares per second. We choose the permanent impact

=10

5

corresponds to a permanent impact of 1 cent for trading 32 shares. For the computation

of d, we choose

T

= 25 to penalize not just for the unhedgable overnight uctuation but for the

hedging costs to be incurred for future days starting the next morning. This penalty accounts for

We choose = 10

5

to corresponds to the gamma position of the entire book. In the expression

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 23

for the gamma of an option (30), (3.5 hours, 0) .1 is the gamma of an At-The-Money option

on Boeing (NYSE:BA) about 3 hours from expiry. Hence, for nearest month options we expect

the gamma of an individual option gamma to be between .01 and .1 (compare with Figure 2).

Therefore, our assumption on the net book corresponds to a position with one to ten million

At-The-Money contracts. Finally, we choose 10

8

. This can be thought of as corresponding to

a relative risk aversion of 1 for an agent with a portfolio of a million dollars.

We now give the derivation of E[

t

[ based on the assumptions of Theorem 1. It is clear that Y

t

is normally distributed with mean zero. From (8) and (15), we obtain a PDE for the variance of

Y

t

as

d

dt

EY

2

t

=2Kh(K(T t))EY

2

t

+()

2

.

We are interested in the more realistic case when d >1 (see Remark 1) whose solution is given by

EY

2

t

=e

2H(t)

(

T

)

2

+()

2

e

2H(t)

_

t

0

e

2H(s)

ds

where

H(t) =kK

_

t

0

coth(kK(T s) +arccoth(d)) ds

=log [sinh(kK(T t) +arccoth(d)) csch(kKT +arccoth(d))] .

Since we have

_

t

0

e

2H(s)

ds =sinh

2

(kKT +arccoth(d))

_

t

0

csch

2

(K(T s) +arccoth(d)) ds

=

sinh

2

(kKT +arccoth(d))

K

[coth(K(T t) +arccoth(d)) coth(KT +arccoth(d))]

we can compute the variance of Y

t

as

EY

2

t

=

sinh

2

(kK(T t) +arccoth(d))

sinh

2

(kKT +arccoth(d))

_

(

T

)

2

+

()

2

K

sinh

2

(kKT +arccoth(d))

_

coth(K(T t) +arccoth(d)) coth(KT +arccoth(d))

_

_

.

Since

t

is normally distributed, we have that

E[[

t

[] =

_

2

coth(K(T t) +arccoth(d))

_

EY

2

t

. (31)

This is plotted in Figure 6b with parameters chosen as in Example 4.

5. Discrete-Time Formulation and Solution

In this section, we assume a constant model as in Theorem 1. We need a discrete-time formulation

and solution to the hedging problem in order to perform the simulations on TAQ data in Section 6.

The simplest discrete strategy would be to evaluate the continuous-time strategy at each time

point in question, buying

t

t shares over the interval [t, t +t]. In eect, this is a forward Euler

Author: Option Hedging with Market Impact

24 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

(a) Average Minutely Trading Volume of Boeing (NYSE:BA) in the

period April 3rd, 2000 to March 30th, 2001.

(b) Intensity of trading E|t| for one trading day with parameters given

in Example 4. In our example, the trading predicted by our model

accounts for 20% of trading ow.

Figure 6 Intraday trading intensity, actual and projected in our model from delta hedging.

discretization of the underlying dynamics. Unfortunately, this strategy results in unrealistic and

costly overshooting.

To illustrate this, consider the mean value of Y

t

, Y

t

= E[Y

t

]. Under the continuous-time policy

of Theorem 1, it would behave as

Y

t

=Y

0

_

t

0

Kh(K(T s))Y

s

ds

and converges exponentially towards 0 but remains positive if Y

0

>0. On the other hand, under a

discrete Euler policy where we purchase

0

t shares, Y

t

would behave as

Y

t

=Y

0

(1 Kh(KT)t) .

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 25

Depending on the size of t, this may not be positive for xed Y

0

> 0. So while this strategy

converges to the continuous strategy as t 0, for xed t, it may overshoot zero, a result which

is known in the literature (see, for example, Ascher and Petzold (1998)). Indeed, simulations using

the discretized Euler-method exhibited this overhedging. In order to obtain well-behaved discrete

time solutions we must pose the discrete-time problem directly. The overshooting is so sever as to

lead to unstable solutions! It is especially prominent when temporary impact is small compared to

K

2

A

2

(T t) (see the denominator of discrete-time solution (33)). The continuous-time solution

is important as it is closed-form and provides important intuition for understanding the problem

dynamics. The discrete-time solution resembles the discretized continuous solution but makes an

important correction for overshooting (33) that is important for practical applications.

5.1. Discrete-Time Formulation

We will discretize the dynamics by imposing a lattice T

N

of N points of width t = T/N. That

is T

N

=

_

T

N

(Z [0, N))

_

. At each time t T

N

, the agent sets his strategy for the entire timestep

[t, t +t). Under such conditions, it is only necessary to consider the implied discrete-time process.

Hence, the agents stock position is given by

X

t

=X

0

+

uTn,u<t

u

while the dynamics for the stock price becomes

P

t

=P

0

+X

t

+

uT

N

,u<t

W

u

where W

kT/N

=W

(k+1)T/N

W

kT/N

. Then the new discrete-time value function becomes

J(t, y) =inf

E

_

uT

N

,ut

_

2

2

Y

2

u

Y

u

u

+

2

2

u

_

t +

2

T

2

Y

2

T

Y

t

=y

_

.

5.2. Problem Solution

Again, we make a quadratic Ansatz that for T t T

N

,

J(T t, y) =A

2

(T t +t)

y

2

2

+A

0

(T t +t) . (32)

Theorem 5. The discrete-time optimal trading intensity

t

=(t, Y

t

) is given by

(t, y) =

KA

2

(T t)

+K

2

A

2

(T t)t

y (33)

and the continuation value J is given by (32) where

A

2

(T t +t) =A

2

(T t) +

2

t +

_

KA

2

(T t)

_

2

+K

2

A

2

(T t)t

t A

2

(0) =

2

T

A

0

(T t +t) =A

0

(T t) +

1

2

2

A

2

(T t)t A

0

(0) =0.

Proof The discrete-time HJB equation becomes

J(T t, y) =inf

t

_

2

2

y

2

y

t

+

2

2

t

_

t +

A

2

(T t)

2

_

_

y +K

t

t

_

2

+()

2

t

_

+A

0

(T t) =0.

Separating both sides by powers of y and using (32) yields the desired result.

Author: Option Hedging with Market Impact

26 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

P

T

T

BA 53.27084 0.0433451 0.8270762 0.0515023

BAC 49.5763872 0.0243846 0.7866773 0.0780991

MSFT 64.9043047 0.0122172 1.4496147 0.1173921

PFE 43.5416817 0.0164636 0.6695676 0.1008441

WMT 52.5306878 0.0208141 0.9813519 0.0773531

Table 2 Summary Statistics of Stocks: the average closing stock price PT , absolute volatility in dollars per share

per square-root seconds , the average overnight volatility in dollars per share T , and the average of a

call-option that matures in 5 days and was At-The-Money at the previous close.

6. Simulation Using TAQ Data

To test the hedging strategy, we use stock TAQ Data to simulate delta hedging a call option

using our trading strategy and compare that to the benchmark Black-Scholes strategy. We choose

ve companies: Boeing (NYSE:BA), Bank of America (NYSE:BAC), Microsoft (NASDAQ:MSFT),

Pzer (NYSE:PFE), and Wal-Mart (NYSE:WMT), each representing a dierent sector of the

economy. Daily NBBO data was collected for the 251 trading days from April 3rd, 2000 to March

30th, 2001 (inclusive) and the mid-price prevailing at each minute of each trading day (9:30AM to

4:00PM) was struck (computed). Summary statistics of the data are given in Figure 2.

We use the price data to calibrate our the discrete-time model (see Section 5) under minutely

rehedging. We then use the data to simulate delta hedging a derivatives position with a at

gamma. We chose to corresponded to that of one million call options that were At-The-Money

at the previous trading days close and mature 5 days after that days close. These quantities are

computed using the Black-Scholes formula.

We can think of the at gamma derivative as approximating that of an At-The-Money call option

under Approximation (14). A call-options gamma prole becomes very narrow in moneyness near

the options expiry so that small uctuations in the stock price will greatly aect the gamma, thus

violating the assumptions of the model. This feature is not unique to our setup but stems from

the kink in the hockey-stick shape payo of the call and the associated diculty of hedging

At-The-Money call options near expiry is a widely recognized problem among practitioners. We

sidestep this issue in our simulation by choosing a call option that expires in 5 days.

We set the initial position X

0

so that the option is initially delta hedged at the previous close.

This (optimistically) simulates the position of a trader who hedges an option across multiple days.

His initial position in the morning may not be hedged due to the overnight uctuation.

We follow the logic of Example 4 in choosing our parameter values. We choose 10

6

. We

assume no permanent impact = 0 and a temporary impact of the form =

p

where

p

> 0

is a proportionality constant and is the absolute volatility of the stock. This accounts for the

well-known stylized fact that, caeteris paribus, market impact is higher for stocks with greater

volatility (Ane and Geman 2000, Cont 2001, Jain and Joh 1988). We choose

p

= 10

2

so that

10

4

as in Example 4. The parameter was chosen based on empirical values while

T

was

chosen to be 10 times its empirical value to induce the agent to hedge aggressively towards the

close. Given our choice of parameter values, the characteristic time-scale at which trading intensity

peaks near the market close is

1

which is on the order of 10 to 20 minutes. In other words, for our liquid stocks, the agent trades

with a constant proportional intensity until the last hours of the trading day.

We track the performance of two dierent agents, one using the proposed hedging intensity of

Section 5 (Model) and another whose strategy is to maintain a Black-Scholes delta hedged (BS).

Author: Option Hedging with Market Impact

Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!) 27

The Black-Scholes trader will not be perfectly hedged due to uctuations in the subsequent minute

interval before rehedging. However, (BS) will likely maintain a tighter hedge on average as he

would be perfectly hedged if the stock did not uctuate in the subsequent interval whereas the

other trader (Model) is not even hedged at the start of the interval to begin with.

The dollar terminal exposure, dollar running exposure, and dollar impact costs are given in

Figure 3. The formulas for these quantities are given by

terminal exposure =[

T

Y

T

[

intraday exposure =

tT

2

Y

2

t

t (34)

impact cost =

tT

2

t

t .

Each term has dimension of dollars to make them directly comparable. Hedging according to the

model in Section 5, (Model) saves $10K a day in market impact costs, while taking on a comparable

amount of risk.

7. Conclusion

Market-impact from hedging a non-trivial outstanding position can greatly increase costs. This

paper develops a highly-tractable framework for analyzing optimal hedging of options for traders

with large positions who face market impact. We use a linear-quadratic framework and nd that

the optimal solution for options hedging is for the agent to trade towards a target portfolio.

The trader nds it prohibitively expensive to hold exactly the Black-Scholes hedge portfolio due

to the market-impact costs and can only trade towards it to minimize the turnover cost. We also

show that our results can be interpreted as a kind of Merton problem where the Merton-optimal

portfolio is the Black-Scholes hedge portfolio.

We show that in the limit of vanishing market-impact costs, we recover that the agent engages

in Black-Scholes hedging. We apply our result to stock-pinning and our predictions are consistent

with the U-shaped intraday trading pattern. Finally, we present the results of numerical simula-

tions which demonstrate the practicality of this technique even for real-world intraday stock-price

uctuations.

Author: Option Hedging with Market Impact

28 Article submitted to Operations Research; manuscript no. (Please, provide the mansucript number!)

Black-Scholes

Terminal Intraday Impact

BA 9.965e+02 9.661e+03 1.235e+04

BAC 1.283e+03 9.300e+03 1.865e+04

MSFT 5.758e+03 1.387e+04 6.022e+04

PFE 1.736e+03 7.984e+03 1.583e+04

WMT 2.142e+03 1.114e+04 2.564e+04

Model, =0.5 10

6

Terminal Intraday Impact

BA 1.086e+03 2.751e+04 5.036e+02

BAC 1.392e+03 3.095e+04 6.780e+02

MSFT 5.858e+03 4.969e+04 2.019e+03

PFE 1.838e+03 2.572e+04 5.163e+02

WMT 2.242e+03 3.641e+04 9.844e+02

Model =1.0 10

6

Terminal Intraday Impact

BA 1.043e+03 2.359e+04 6.779e+02

BAC 1.339e+03 2.641e+04 8.921e+02

MSFT 5.808e+03 4.267e+04 2.585e+03

PFE 1.789e+03 2.205e+04 6.686e+02

WMT 2.193e+03 3.116e+04 1.281e+03

Model, =2.0 10

6

Terminal Intraday Impact

BA 1.020e+03 2.034e+04 9.253e+02

BAC 1.311e+03 2.258e+04 1.192e+03

MSFT 5.783e+03 3.667e+04 3.401e+03

PFE 1.763e+03 1.894e+04 8.820e+02

WMT 2.167e+03 2.672e+04 1.700e+03

Table 3 Summary Statistics of Simulation

Summary Statistics of Simulation: Average dollar exposure versus dollar market impact by stock

for a simulated Black-Scholes trader and one that follows our Model. See (34) for details of the

terms.

References

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