Risk-return arguments applied to options with trading costs

Details Risk-return arguments applied to options with trading costs Risk-return arguments applied to options with trading costs

1998-03-19

arxiv.org/abs/cond-mat/9803238v1

Physics

Condensed Matter

Statistical Mechanics

10 pages, in LaTeX, no figures, Paper to be published in the Proceedings of the conference "Disorder and Chaos", in memory of

Scientific paper

We study the problem of option pricing and hedging strategies within the frame-work of risk-return arguments. An economic agent is described by a utility function that depends on profit (an expected value) and risk (a variance). In the ideal case without transaction costs the optimal strategy for any given agent is found as the explicit solution of a constrained optimization problem. Transaction costs are taken into account on a perturbative way. A rational option price, in a world with only these agents, is then determined by considering the points of view of the buyer and the writer of the option. Price and strategy are determined to first order in the transaction costs.

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