Option valuation with liquidity risk and jumps

ABSTRACT

This article provides a simple model for pricing and hedging options in the presence of jumps and liquidity costs. In the article, liquidity risk is modelled via a stochastic supply curve function and a jump-diffusion process is approximated by a Markov chain. Local risk minimization incorporating liquidity risk is proposed to price and hedge European options in this discrete-time model. Moreover, an example is provided to implement the modified risk minimization method and to demonstrate the performance of hedging strategies.

KEYWORDS:

• Option pricing
• jump-diffusion model
• liquidity risk
• local risk minimization

JEL CLASSIFICATION:

• G13
• G19
• C65

Disclosure statement

No potential conflict of interest was reported by the authors.

Additional information

Funding

This research has been supported by Natural Sciences and Engineering Research Council of Canada, Discovery grant.