Options hedging under liquidity costs

This is the latest version of this item.

Following the framework of Cetin, Jarrow and Protter (CJP) we study the problem of super-replication in presence of liquidity costs under additional restrictions on the gamma of the hedging strategies in a generalized Black-Scholes economy. We find that the minimal super-replication price is different than the one suggested by the Black-Scholes formula and is the unique viscosity solution of the associated dynamic programming equation. This is in contrast with the results of CJP who find that the arbitrage free price of a contingent claim coincides with the Black-Scholes price. However, in CJP a larger class of admissible portfolio processes is used and the replication is achieved in the L^2 approximating sense.