Option pricing in exponential L\'evy models with transaction costs

TL;DR

This paper develops a method for pricing European call options with transaction costs in models where stock prices follow exponential Lévy processes, extending utility-based approaches and solving associated control problems numerically.

Contribution

It generalizes existing models to include exponential Lévy processes and provides a numerical solution framework for the resulting stochastic control problems.

Findings

Numerical solutions for diffusion, Merton, and Variance Gamma processes.

Option prices computed for both buyers and writers.

The approach handles general exponential Lévy models with transaction costs.

Abstract

We present an approach for pricing European call options in presence of proportional transaction costs, when the stock price follows a general exponential L\'{e}vy process. The model is a generalization of the celebrated work of Davis, Panas and Zariphopoulou (1993), where the value of the option is defined as the utility indifference price. This approach requires the solution of two stochastic singular control problems in finite horizon, satisfying the same Hamilton-Jacobi-Bellman equation, with different terminal conditions. We introduce a general formulation for these portfolio selection problems, and then we focus on the special case in which the probability of default is ignored. We solve numerically the optimization problems using the Markov chain approximation method and show results for diffusion, Merton and Variance Gamma processes. Option prices are computed for both the writer and the buyer.