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European option pricing with transaction cousts

Davis, Mark H.A. ; Panas, Vassilios ; Zariphopoulou, Thaleia ;
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    The authors consider the problem of pricing European options in a market model similar the Black-Scholes one, except that proportional transaction charges are levied on all sales and purchases of stock. "Perfect replication" is no longer possible, and holding an option involves an essential element of risk. A definition of the option writing price is obtained by comparing the maximum utilities available to the writer by trading in the market with and without the obligation to fulfull the terms of an option contract at the exercise time. This definition reduces to the Black-Scholes value when the transaction costs are removed. Computing the price involves solving two stochastic optimal control problems. This paper shows that the value functions of these problems are the unique viscosity solutions, with different boundary conditions, of a fully nonlinear quasi-variational inequality. This fact implies convergence of discretisation schemes based on the "binomial" approximation of the stock price. Computational results are given. In particular, the authors show that, for a long dated option, the writer must charge a premium over the Black-Scholes price that is just equal to the transaction charge for buying one share.


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