Option replication and arbitrage trading strategy with liquidity and transaction costs

Abstract

This study investigates the pricing of option by using the optimal hedging strategy for super-replicating an option in which the underlying asset is not perfectly liquid and there are transaction costs. The theoretical analysis and empirical evidence are conducted in the Thai option market. Since the continuous trading is impossible to implement in practice, discrete trading strategies are defined in this study. The optimal hedging strategy provides an advantage of assuring that the value of the replicating portfolio is not less than the option’s liability at maturity. The empirical results reveal the significant positivity of the liquidity parameter which implies the upward-sloping of the supply curve. This supply curve is consistent with the market microstructure literature and assumes that the underlying security prices depend on trading volume and direction. This study finds that the liquidity cost has a bigger impact on the option prices than the transaction cost in the Thai market. Moreover, the difference between model prices (with liquidity and transaction costs included) and actual market prices in each option series will allow us to implement an arbitrage trading strategy when the model prices are lower than the market prices. The trading strategy of buying stock and selling the option will be exploited in the Thai market. The results show some positive profits which means that this arbitrage trading strategy succeeds