AN EMPIRICAL STUDY OF THE HEDGING OF EUROPEAN CALL OPTIONS WITH TRANSACTION COSTS

Abstract

The Black-Scholes options hedging strategy is only functional in capital markets with no transaction costs. As this is an unrealistic assumption, studies have been done to figure out hedging strategies that do account for transaction fees. Leland initiated this stream of research with his modified volatility method. Following, utility maximization strategies for hedging a contingent claim, specifically a European call, have been developed through pioneering research done by Davis, Panas, and Zariphopoulou and continued by Hodges and Neuberger to evaluate the trade-off between hedging errors and transaction costs. Formulas for the area, also known as the no-transaction zone, in which an investor should reside in to best hedge an option payoff have been deduced, but the open-formed solution is very difficult to compute. While this paper reviews a wide breadth of strategies, our empirical study aims to assess strategies that are simple enough to implement. We evaluate these strategies in a risk-return framework and found that the variable bandwidth strategy performed the best for moderate levels of risk aversion, but there is no optimal strategy for all risk tolerance levels.