Hedging Strategies of Financial Intermediaries : Pricing Options with a Bid-Ask Spread

This paper uses a model similar to the Boyle-Vorst and Ritchken-Kuo arbitrage-free models for the valuation of options with transaction costs to determine the maximum price to be charged by the financial intermediary writing an option in a non-auction market. Earlier models are extended by recognizing that, in the presence of transaction costs, the price-taking intermediary constructing a hedging portfolio faces a tradeoff: to choose a short trading interval with small hedging errors and high transaction costs, or a long trading interval with large hedging errors and low transaction costs. The model presented recognizes that when transaction costs induce less frequent portfolio adjustments, investors are faced with a multinomial distribution of asset returns rather than a binomial one. The price upper bound is determined by selecting the trading frequency that will equalize the marginal benefit from decreasing hedging errors and the marginal cost of transactions