Hedging Strategies of Financial Intermediaries: Pricing Options with a Bid-Ask Spread

The Financial Review, Vol. 30, No. 4, pp. 809-822, November 1995

14 Pages Posted: 19 Feb 2008 Last revised: 8 Oct 2013

See all articles by Shmuel Hauser

Shmuel Hauser

Ben-Gurion University of the Negev - School of Management; Government of the State of Israel - Israel Securities Authority

Azriel Levy

Hebrew University of Jerusalem; Bank of Israel

Uzi Yaari

Rutgers University; School of Business-Camden

Abstract

This paper uses a model similar to the Boyle-Vorst and Ritchken-Kuo arbitrage-free models for the valuation of options with transaction costs to determine the maximum price to be charged by the financial intermediary writing an option in a non-auction market. Earlier models are extended by recognizing that, in the presence of transaction costs, the price-taking intermediary constructing a hedging portfolio faces a tradeoff: to choose a short trading interval with small hedging errors and high transaction costs, or a long trading interval with large hedging errors and low transaction costs. The model presented recognizes that when transaction costs induce less frequent portfolio adjustments, investors are faced with a multinomial distribution of asset returns rather than a binomial one. The price upper bound is determined by selecting the trading frequency that will equalize the marginal benefit from decreasing hedging errors and the marginal cost of transactions.

Keywords: option pricing, hedging portfolio, portfolio adjustment frequency, transaction costs

JEL Classification: G11, G12, G13

Suggested Citation

Hauser, Shmuel and Levy, Azriel and Yaari, Uzi, Hedging Strategies of Financial Intermediaries: Pricing Options with a Bid-Ask Spread. The Financial Review, Vol. 30, No. 4, pp. 809-822, November 1995, Available at SSRN: https://ssrn.com/abstract=1094546

Shmuel Hauser

Ben-Gurion University of the Negev - School of Management ( email )

P.O. Box 653
Beer-Sheva 84105
Israel
+972 2 651 3939 (Phone)
+972 7 6472896 (Fax)

Government of the State of Israel - Israel Securities Authority

22 Kanfei Nesharim Street
Jerusalem 95464
Israel

Azriel Levy

Hebrew University of Jerusalem ( email )

Mount Scopus
Jerusalem, Jerusalem 91905
Israel

Bank of Israel

P.O. Box 780
Jerusalem, 91907
Israel

Uzi Yaari (Contact Author)

Rutgers University ( email )

School of Business
Camden, NJ 08102
United States
610-664-2086 (Phone)

HOME PAGE: http://camden-sbc.rutgers.edu/FacultyStaff/Directory/yaari.htm

School of Business-Camden ( email )

Rutgers University
227 Penn Street
Camden, NJ 08102
United States
610-664-2086 (Phone)
610-664-2198 (Fax)

HOME PAGE: http://camden-sbc.rutgers.edu/FacultyStaff/Directory/yaari.htm

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