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Option Replication in Discrete Time with Transaction Costs
Author(s) -
BOYLE PHELIM P.,
VORST TON
Publication year - 1992
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1992.tb03986.x
Subject(s) - transaction cost , replication (statistics) , extension (predicate logic) , portfolio , replicating portfolio , binomial options pricing model , interval (graph theory) , range (aeronautics) , discrete time and continuous time , computer science , valuation of options , cover (algebra) , database transaction , black–scholes model , econometrics , mathematical optimization , mathematical economics , mathematics , economics , financial economics , microeconomics , portfolio optimization , statistics , mechanical engineering , materials science , combinatorics , engineering , composite material , programming language , volatility (finance)
Option replication is discussed in a discrete‐time framework with transaction costs. The model represents an extension of the Cox‐Ross‐Rubinstein binomial option pricing model to cover the case of proportional transaction costs. The method proceeds by constructing the appropriate replicating portfolio at each trading interval. Numerical values of these prices are presented for a range of parameter values. The paper derives a simple Black‐Scholes type approximation for the option prices with transaction costs and demonstrates numerically that it is quite accurate for plausible parameter values.