Hedging Under an Expected Loss Constraint with Small Transaction Costs
42 Pages Posted: 21 Oct 2014 Last revised: 9 Dec 2016
Date Written: March 8, 2016
We consider the problem of option hedging in a market with proportional transaction costs. Since super-replication is very costly in such markets, we replace perfect hedging with an expected loss constraint. Asymptotic analysis for small transaction costs is used to obtain a tractable model. A general expansion theory is developed using the dynamic programming approach. Explicit formulae are obtained in the special cases of exponential and power utility functions. As a corollary, we retrieve the asymptotics for the exponential utility indifference price.
Keywords: Expected loss constraint, hedging, transaction cost, asymptotic expansion
JEL Classification: C61; G11
Suggested Citation: Suggested Citation