Game options with gradual exercise and cancellation under proportional transaction costs

TL;DR

This paper investigates game options with gradual exercise and cancellation under proportional transaction costs, providing new algorithms and dual representations that improve hedging strategies and price bounds.

Contribution

It introduces a novel framework for game options allowing gradual exercise and cancellation, with algorithms for pricing and superhedging in a multi-asset market.

Findings

Tighter bid-ask price bounds compared to instantaneous exercise models

Algorithmic methods for superhedging strategies and optimal stopping times

Probabilistic dual representations for bid and ask prices

Abstract

Game (Israeli) options in a multi-asset market model with proportional transaction costs are studied in the case when the buyer is allowed to exercise the option and the seller has the right to cancel the option gradually at a mixed (or randomised) stopping time, rather than instantly at an ordinary stopping time. Allowing gradual exercise and cancellation leads to increased flexibility in hedging, and hence tighter bounds on the option price as compared to the case of instantaneous exercise and cancellation. Algorithmic constructions for the bid and ask prices, and the associated superhedging strategies and optimal mixed stopping times for both exercise and cancellation are developed and illustrated. Probabilistic dual representations for bid and ask prices are also established.