Option Hedging with Transaction Costs

Sammanfattning: This thesis explores how transaction costs affect the optimality of hedging when using Black-Scholes option pricing model. Further, a number of models developed to improve the hedging results of Black-Scholes, when accounting for transaction costs, are analysed and compared. To numerically evaluate these strategies, extensive Monte-Carlo simulations are generated and the results of the strategies are computed in risk-return frameworks. The general finding is that the variable bandwidth delta and fixed bandwidth delta strategy showed the best results, whereas Black-Scholes model expectedly generated poor results. However, slightly unpredictably the asset tolerance strategy did not outperform the Black-Scholes strategy. While an overall ranking between the hedging approaches could be defined, the optimal strategy and the relative difference between the strategies varied with the level of risk aversion.