Hedging Under an Expected Loss Constraint with Small Transaction Costs

We consider the problem of option hedging in a market with proportional transaction costs. Since super-replication is very costly in such markets, we replace perfect hedging with an expected loss constraint. Asymptotic analysis for small transaction costs is used to obtain a tractable model. A general expansion theory is developed using the dynamic programming approach. Explicit formulae are obtained in the special cases of exponential and power utility functions. As a corollary, we retrieve the asymptotics for the exponential utility indifference price.

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