OPTIMAL PARTIAL HEDGING OF OPTIONS WITH SMALL TRANSACTION COSTS

This study uses asymptotic analysis to derive optimal hedging strategies for option portfolios hedged using an imperfectly correlated hedging asset with small fixed and/or proportional transaction costs, obtaining explicit formulae in special cases. This is of use when it is impractical to hedge using the underlying asset itself. The hedging strategy holds a position in the hedging asset whose value lies between two bounds, which are independent of the hedging asset's current value. For low absolute correlation between hedging and hedged assets, highly risk-averse investors and large portfolios, hedging strategies and option values differ significantly from their perfect market equivalents. (C) 2011 Wiley Periodicals, Inc. Jrl Fut Mark 31: 855-897, 2011