Options under Proportional Transaction Costs: An Algorithmic Approach to Pricing and Hedging

The paper is devoted to optimal superreplication of options under proportional transaction costs on the underlying asset. General pricing and hedging algorithms are developed. This extends previous work by many authors, which has been focused on the binomial tree model and options with specific payoffs such as calls or puts, often under certain bounds on the magnitude of transaction costs. All such restrictions are hereby removed. The results apply to European options with arbitrary payoffs in the general discrete market model with arbitrary proportional transaction costs. Numerical examples are presented to illustrate the results and their relationships to the earlier work on pricing options under transaction costs.     

Penalty Approach to the HJB Equation Arising in European Stock Option Pricing with Proportional Transaction Costs

We present a novel penalty approach to the Hamilton-Jacobi-Bellman (HJB) equation arising from the valuation of European options with proportional transaction costs. We first approximate the HJB equation by a quasilinear 2nd-order partial differential equation containing two linear penalty terms with penalty parameters λ ₁ and λ ₂ respectively. Then, we show that there exists a unique viscosity solution to the penalized equation. Finally, we prove that, when both λ ₁ and λ ₂ approach infinity, the viscosity solution to the penalized equation converges to that of the corresponding original HJB equation.     

The Obstacle Version of the Geometric Dynamic Programming Principle: Application to the Pricing of American Options Under Constraints

We provide an obstacle version of the Geometric Dynamic Programming Principle of Soner and Touzi (J. Eur. Math. Soc. 4:201–236, 2002) for stochastic target problems. This opens the doors to a wide range of applications, particularly in risk control in finance and insurance, in which a controlled stochastic process has to be maintained in a given set on a time interval [0,T]. As an example of application, we show how it can be used to provide a viscosity characterization of the super-hedging cost of American options under portfolio constraints, without appealing to the standard dual formulation from mathematical finance. In particular, we allow for a degenerate volatility, a case which does not seem to have been studied so far in this context.     

Generalized Tractability for Multivariate Problems Part II: Linear Tensor Product Problems, Linear Information, and Unrestricted Tractability

We continue the study of generalized tractability initiated in our previous paper “Generalized tractability for multivariate problems, Part I: Linear tensor product problems and linear information”, J. Complex. 23:262–295, 2007. We study linear tensor product problems for which we can compute linear information which is given by arbitrary continuous linear functionals. We want to approximate an operator S _d given as the d-fold tensor product of a compact linear operator S ₁ for d=1,2,…, with ‖S ₁‖=1 and S ₁ having at least two positive singular values. Let n(ε,S _d ) be the minimal number of information evaluations needed to approximate S _d to within ε∈[0,1]. We study generalized tractability by verifying when n(ε,S _d ) can be bounded by a multiple of a power of T(ε ⁻¹,d) for all (ε ⁻¹,d)∈Ω⊆[1,∞)×ℕ. Here, T is a tractability function which is non-decreasing in both variables and grows slower than exponentially to infinity. We study the exponent of tractability which is the smallest power of T(ε ⁻¹,d) whose multiple bounds n(ε,S _d ). We also study weak tractability, i.e., when . In our previous paper, we studied generalized tractability for proper subsets Ω of [1,∞)×ℕ, whereas in this paper we take the unrestricted domain Ω ^unr=[1,∞)×ℕ. We consider the three cases for which we have only finitely many positive singular values of S ₁, or they decay exponentially or polynomially fast. Weak tractability holds for these three cases, and for all linear tensor product problems for which the singular values of S ₁ decay slightly faster than logarithmically. We provide necessary and sufficient conditions on the function T such that generalized tractability holds. These conditions are obtained in terms of the singular values of S ₁ and mostly asymptotic properties of T. The tractability conditions tell us how fast T must go to infinity. It is known that T must go to infinity faster than polynomially. We show that generalized tractability is obtained for T(x,y)=x ^1+ln y . We also study tractability functions T of product form, T(x,y)=f ₁(x)f ₂(x). Assume that a _i =lim inf  _x→∞(ln ln f _i (x))/(ln ln x) is finite for i=1,2. Then generalized tractability takes place iff