Modified Leland’s Strategy for a Constant Transaction Costs Rate

Mathematical Finance, Forthcoming

12 Pages Posted: 13 Apr 2012

See all articles by Emmanuel Lepinette

Emmanuel Lepinette

Université Paris-Dauphine - CEREMADE, CNRS

Date Written: February 12, 2012

Abstract

In 1985 Leland suggested an approach to price contingent claims under proportional transaction costs. Its main idea is to use the classical Black–Scholes formula with a suitably adjusted volatility for a periodical revision of the portfolio whose terminal value approximates the pay-off. Unfortunately, if the transaction costs rate does not depend on the number of revisions, the approximation error does not converge to zero as the frequency of revisions tends to infinity. In the present paper, we suggest a modification of Leland’s strategy ensuring that the approximation error vanishes in the limit.

Keywords: Black–Scholes formula, transaction costs, Leland’s strategy, approximate hedging

JEL Classification: G11

Suggested Citation

Lepinette, Emmanuel, Modified Leland’s Strategy for a Constant Transaction Costs Rate (February 12, 2012). Mathematical Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2038777

Emmanuel Lepinette (Contact Author)

Université Paris-Dauphine - CEREMADE, CNRS ( email )

Place du Marechal de Lattre de Tassigny
Paris Cedex 16, 75775
France

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