Option Pricing and Replication with Transactions Costs

ABSTRACT Transactions costs invalidate the Black‐Scholes arbitrage argument for option pricing, since continuous revision implies infinite trading. Discrete revision using Black‐Scholes deltas generates errors which are correlated with the market, and do not approach zero with more frequent revision when transactions costs are included. This paper develops a modified option replicating strategy which depends on the size of transactions costs and the frequency of revision. Hedging errors are uncorrelated with the market and approach zero with more frequent revision. The technique permits calculation of the transactions costs of option replication and provides bounds on option prices.