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On the Mean-Variance Tradeoff in Option Replication with Transactions Costs

Published online by Cambridge University Press:  06 April 2009

Klaus Bjerre Toft
Klaus Bjerre Toft
Affiliation:
Department of Finance, CBA 6.272, Graduate School of Business, The University of Texas at Austin, Austin, TX 78712-1179.
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Abstract

This paper analyzes the tradeoff between cost and risk of discretely rebalanced option hedges in the presence of transactions costs. I present closed form solutions for expected hedging error, transactions costs, and variance of the cash flow from a time-based hedging strategy similar to that analyzed by Leland (1985). Furthermore, I characterize the cost and risk of a move-based hedging strategy without resorting to Monte Carlo simulations. All results are sufficiently general to accommodate the use of a transactions costs adjusted hedging volatility and an asset rate of return that differs from the risk-free rate of return.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 31 , Issue 2 , June 1996 , pp. 233 - 263
Copyright
Copyright © School of Business Administration, University of Washington 1996

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