Communications in Mathematical Sciences
Volume 14 (2016)
Option replication in discrete time with the cost of illiquidity
Pages: 1947 – 1962
We introduce a model of liquidity risk through a stochastic supply curve for price taking traders. The supply curve gives the actual execution cost investors face in trading assets. We use the solutions to the modified Black–Scholes type PDE and obtain the delta-hedging strategies. We then show the replicating portfolio including liquidity costs converges to the payoff of the option. We demonstrate the replication error of discrete-time trading strategy decreases with inhomogeneous rebalancing times, and investigate an optimal positioning of them.
option replication, inhomogeneous rebalancing, liquidity risk, illiquidity
2010 Mathematics Subject Classification
91B24, 91G20, 91G80