An Endogenous Volatility Approach

to Pricing and Hedging Call Options with

Transaction Costs
Leonard C. MacLean

Yonggan Zhao

William T. Ziemba

September 28, 2009

JEL Classification: B23 C15 C61 G13

Leonard C. MacLean: School of Business Administration, Dalhousie University, Halifax, NS,

Canada B3H 3J5. Email: lmaclean@mgmt.dal.ca

Yonggan Zhao: RBC Center for Risk Management and School of Business Administration, Dalhousie University, Halifax, NS, Canada B3H 3J5. E-mail: Yonggan.Zhao@Dal.Ca.

William T. Ziemba: Sauder School of Business, University of British Columbia, Vancouver, BC,
Canada, V6T 1Z2 (Emeritus), and Visiting Professor, Mathematical Institute, Oxford University, 2429, St. Giles Street, Oxford, OX1 3LB, UK. E-mail: wtzimi@mac.com.

Electronic copy available at: http://ssrn.com/abstract=1481415

An Endogenous Volatility Approach

to Pricing and Hedging Call Options with Transaction
Costs
Abstract
Standard delta hedging fails to exactly replicate a European call option in the
presence of transaction costs. We study a pricing and hedging model similar to the
delta hedging strategy with an endogenous volatility parameter for the calculation of delta over time. The endogenous volatility depends on both the transaction
costs and the option strike prices. The optimal hedging volatility is calculated
using the criterion of minimizing the weighted upside and downside replication
errors. The endogenous volatility model with equal weights on the up and down
replication errors yields an option premium close to the Leland (1985) heuristic
approach. The model with weights being the probabilities of the options moneyness provides option prices closest to the actual prices. Option prices from the
model are identical to the Black-Scholes option prices when transaction costs are
zero. Data on S&P 500 index cash options from January to June 2008 illustrate
the model.

Electronic copy available at: http://ssrn.com/abstract=1481415

1. Introduction
In the theory of option pricing, the goal is to create a replicating portfolio whose payoff equals the value of the option at some exercise date. In the Black-Scholes-Merton
(BSM) framework, delta hedging achieves that goal. The celebrated BSM formula
for pricing a European call option is based on two assumptions: (i) the underlying
stock price follows geometric Brownian motion; and (ii) trading has neither restrictions nor costs. Assumption (ii) does not hold and the theory fails, so the replicating
strategy has hedging error. One symptom of this failure is implied volatility skewness. It is observed that equity option prices are consistently higher (lower) than the
Black-Scholes-Merton model prices for in- (out-of-) the-money call options, so implied
volatilities of in- (out-of-) the-money options are higher (lower) than at-the-money
ones.
Several researchers have considered the shortcomings of the BSM pricing formula.
An alternative to the geometric Brownian motion approach is the binomial pricing
model (Cox, Ross, and Rubinstein 1979.) Boyle and Vorst (1992) designed a perfect
hedging strategy in the binomial model with transaction costs. The perfect hedge is
possible due to the assumption of a binomial process for the underlying stock price.
They also developed a similar risk neutral valuation approach that is a two state
Markov process. Edirisinghe, et al. (1993) developed a general replicating strategy,
in the framework of optimization, by minimizing the initial cost subject to the hedging
portfolio payoff being at least as large as the options payoff. They indicated that it is
not necessarily optimal to revise the portfolio at each rebalance time.
Accepting the geometric Brownian motion assumption, but introducing transaction costs on trading , Leland (1985) proposed a strategy in which the volatility for
the calculation of delta is increased by a term which is related to the transaction cost
rate and the length of the rebalance interval. As the option premium is positively
related to the volatility, the intention in augmenting the volatility was to increase
the option premium with trading frequency for a given proportional transaction cost
rate. However, as pointed out by Kabanov and Safarian (1997), this strategy does not

guarantee a perfect replication of a call option in the limit (continuous trading). The
mathematical error in the Leland claim of perfect replication is discussed by Zhao
and Ziemba (2007a and 2007b) and Leland (2007).
A neglected aspect of the Leland approach is that the strike price of an option
does not appear in the expression for the augmented volatility, even though the implied volatilities are not constant across all levels of strike prices. This suggests that
relating the augmented volatility to the options strike price can adjust for skewness.
In this paper, we develop an option pricing and hedging model based on portfolio
replication techniques. The objective is to modify the Leland approach by linking the
hedging volatility to both transaction costs and the strike prices. Instead of using
an exogenous augmented volatility, we endogenize the volatility in an optimization
problem. The hedging volatility is selected to minimize the weighted mean absolute
replication error. The total replication error is divided into two quantities, the downside shortfall and the upside gain, which are weighted by the probabilities that the
option is in or out of the money, respectively. As the probability of the moneyness of
the option increases, the downside shortfall is considered to be more significant. Similarly, as the probability of the moneyness increases, the upside gain is considered less
significant. With the endogenized volatility, it is possible to examine whether and
how transaction costs explain the skewness of equity options across a range of strike
prices. Since the probability that the call option is in the money decreases with the
level of the strike price, the weighing of the downside shortfall and the upside gain
generates skewness of the hedging volatilities across different strike prices.
The endogenous volatility approach is compared with the Leland and the BlackScholes approaches in numerical experiments. Using S&P 500 cash options, simulation results show that option prices for the endogenous volatility model are closer to
the actual prices than prices from other models, especially for deep in-the-money and
deep out-of-the-money options. This result is consistent with the volatility skewness.
Option prices from the endogenous volatility model are identical to the Black-Scholes
option prices if transaction costs are ignored.

2. A Pricing and Hedging Model

The Black-Scholes-Merton theory for options pricing has important restrictions in
terms of the dynamics of the underlying stock price and the frictionless trading market. Lelands modification of the theory to incorporate transactions costs also has
limitations. In this section a new approach to option pricing with transactions costs
is developed. As in Lelands model, transactions costs affect the hedging volatility,
and the geometric Brownian motion and trading frequency assumptions are the same
as those in the BSM model. An optimization problem linking volatility to strike price
is defined and the corresponding option prices and hedging errors are related to the
BSM and Leland approaches .

2.1. Volatilities and the Hedging Strategies

Standard option pricing theory suggests that the implied volatilities for all option contracts with different strikes should be the same in an orderly market. However, evidence from the equity option market has shown that implied volatilities are heavily
skewed. Market prices of options are usually higher (lower) than the Black-ScholesMerton prices for in (out of) the money call options. This market imperfection has
been documented as volatility skewness in Rubinstein (1994).
One reason for this imperfection is the presence of transaction costs. Leland (1985)
considered the idea that the increment of the option premium induced by an augmented volatility can offset the necessary transaction costs. However, the hedging
portfolio does not replicate the option payoff. A possible explanation for the price
deviation with Lelands approach is that the augmented volatility does not depend
on the options strike prices. In this section we develop a method which relates the
hedging volatilities to both transaction costs and strike prices. We use the following
notation:

round trip transaction cost.

option strike price.

option exercise date.

risk free rate.

N ()

cumulative normal distribution function.

instantaneous stock volatility.

hedging volatility for the delta hedging strategy.

To set up an alternative adjusted volatility model within the BSM setting, we

assume the dynamics of the underlying security follow geometric Brownian motion.
Let St be the security price at time t. Then the price dynamics are
dS
S

= r dt + dZ,

(1)

where Z is a standard Brownian motion. This setting indicates that we are working under a risk neutral probability measure. We only consider hedging that takes
place at a finite number of time points. Two popular strategies are: (i) the delta
hedging strategy with fixed time rebalancing, and (ii) the delta hedging strategy with
times determined by the price movement in the underlying security. We consider
fixed times, so that comparisons with the BSM and the Leland models are based on
the alternative approaches to the hedging volatility.
Let i , i = 1, ...n, be the time epochs when hedging trades take place for a given
horizon with 0 = 0 and n+1 = T . While the option writer holds N (di ) shares at
trading epoch i , where di =

ln

S
i
K

+(r+ 1

2 )(T i )
2
,

T i

the amount in the trading account

is, for i = 1, ..., n,

B0 = C0 (1 + q/2)S0

i+1

= Bi eri (1 + sgn(N (di+1 ) N (di ))q/2)Si+1 (N (di+1 ) N (di )),

where C0 is the initial price of the call option given by the BSM formula

C0 = S0 N (d0 ) KerT N (d0

T ).
6

Hence, the terminal payoff of the hedging portfolio at the options expiration date is
PT = Bn er(Tn ) + (1 q/2) ST N (dn ).

(2)

The focus is on the volatility estimate

. In BSM the estimate is simply the standard deviation of stock returns and is independent of transaction costs and strike
prices. The hedging volatility proposed by Leland (1985) is
s
r
2
q

= 1+

t
which depends on the transaction cost q but not on the strike prices. In our endogenous approach, the hedging volatility will depend on both the transactions cost and
strike price.

2.2. Hedging Error and Endogenous Volatility

The payoff on the call option with strike price K is CT = (ST K)+ at the expiration date T . For a trajectory of stock prices, the delta hedging strategy has replication
error, with absolute value |PT CT |. The mean absolute error is E[|PT CT |]. The
upside and downside replication errors are E[(PT CT )+ ] and E[(PT CT ) ], respectively. The rationale for separating the error into scenarios with gains and losses
is the different perceptions or utility that an investor would assign to such scenarios.
Investors may view the upside replication gains differently from the downside replication losses. Empirical evidence shows that the implied volatilities for equity options
are heavily skewed, which suggests that risk perception is not symmetric. It is proposed that risk aversion depends on the moneyness of the option. If the probability
that the option expires in the money is large, investors may be concerned about the
downside replication losses, considering the issued option as a liability. Similarly, if
the probability that the option expires out of the money is small, the replication gains
will not be significant to the writer of the option. An investor would like to weigh the
upside gains and downside losses according to the options moneyness.

Let K be the probability that the option with strike price K ends valueless at the
expiry date, i.e.,
K = Pr[ST K],
which implies that
K = N (

1
ln(S0 /K)+(r 2 )T
2

).

With the fixed parameters = {S0 , K, r, T, K, , q, 1 , ...n }, consider the weighted

mean errors criterion for determining volatility




(
, ) = K () E (PT CT )+ |
, + (1 K ) E (PT CT ) |
, .

(3)

Equation (3) can be viewed as the expected performance, in terms of hedging error,
using the probability measure induced by the moneyness of the option. Since the
probability that the option is out of the money at expiration increases with the level
of the strike prices, the interest in hedging the downside error should decrease as the
option strike price increases. Correspondingly, the investor prefers to charge a higher
premium for deep in the money options and lower premium for deep out-of-the-money
options than the BSM options prices.
The performance measure depends on several parameters. The main attention
is on the hedging volatility parameter
. So, holding other parameters constant, the
objective is to determine the adjusted volatility with the best performance. The writer
of the call option will solve the nonlinear optimization model
min (
, ).

>0

(4)

The solution to (4) depends on the parameter vector and particularly the transaction
costs and the strike prices. There are some important properties of the endogenous
volatility problem as an alternative to the BSM or Leland hedging approaches.
The BSM option price is a special instance of the solution to the optimization
model (4) if transaction costs are zero. Moreover, as the trading interval approaches zero, which implies a continuous trading in the limit, both the upside
replication gains and the downside replication losses must tend to zero, since
8

an exact hedge can be achieved in the framework of continuous trading without

transaction costs. Thus, the optimization model (4) is consistent with the BSM
model.
If the weights reflecting risk aversion are selected as K () = 0.5 (indifference
between gains and losses), so that the average absolute replication error is minimized, the optimal volatility is close to Lelands formula, which approximately
minimizes mean squared errors.
The weights from the moneyness probability will introduce a correction for the
bias of hedging prices. The weights have an effect of tilting the prices, aligning
them closer to true prices.
Since there is only one variable in the nonlinear optimization model (4), an efficient
algorithm can be applied to the solution for the optimal endogenous volatility. A
Matlab code was written to solve this problem.

3. Empirical Tests
The objective in proposing a new method for delta hedging is to address some of
the problems with the BSM and Leland approaches. The outcome measures are: (i)
volatility skewness; (ii) pricing bias; and (iii) hedging error. The endogenous volatility
approach is expected to improve performance on those dimensions over the standard
methods. Evidence of improved performance is provided in this section.
The comparator option pricing and hedging models have the same assumptions
for the stock dynamics - geometric Brownian motion, and option type - European call
option. Data on S&P 500 index options are used for the model input to compare the
simulation results with the actual option prices. The instantaneous stock volatility
is estimated as the sample standard deviation, based on the maximum likelihood
method. The risk free rate is set to be the average of the US six month term deposit
rates for that period. The index level was S0 = 892.5 on December 18, 2008. Estimated as the sample standard deviation, the annualized volatility of the index return
9

is 34.61%. The range of the strike prices used in this study is from 750 to 1100 in
25 point increments. The round-trip proportional transaction costs used to study how
the option prices are affected by the level of transaction cost rate are 0 (no cost), 0.3%,
0.6%, 0.9%, 1.2%, and 1.5%. The options expired on June 18, 2009, which indicates
a total of 130 days for the hedging to take place. For the significance of this study,
the number of scenarios is set to 10000. We simulate 10000 paths of the underlying
asset prices using the estimated parameters from the data. We then apply a process
control strategy to implementing portfolio hedging over time, taking transaction costs
into consideration. The key innovation in the approach is the calculation of the adjusted volatility. Instead of exogenously specifying an adjusted volatility for the BSM
formula, we endogenize the hedging volatility for the calculation of delta hedging.
The optimal hedging volatility is determined by minimizing the weighted upside and
downside hedging errors at the expiry date of the call option.
For the rest of this section, we study model performance based on the different
criteria. For comparison with the BSM and the Leland models, we consider the endogenized volatility model with two weighting schemes for the upside and downside
hedging errors, (i) EV1: equal weights, (ii) EV2: moneyness probability weights.

3.1. Volatility Skewness

It is observed that equity option prices are consistently higher (lower) than the BSM
model prices for in (out-of) -the-money options, so implied volatilities of in (out-of) the-money call options are higher (lower) than at-the-money ones. A motivating principle for endogenizing volatility is to link the hedging volatility not only to transaction
costs but also to strike prices. The hedging volatilities for the various models are given
in Table I and plotted in Figure 1. The BSM volatility, which was estimated as 34.61%
per annum, does not vary by transaction cost or strike price, the Leland volatilities
vary by transaction cost, and the endogenous volatilities vary by both transaction cost
and strike price.
From Table I, the hedging volatility increases with transaction costs for all models.

10

Table I: Hedging Volatilities

for Various Models
Model

Strike

0%

0.3%

0.6%

0.9%

1.2%

1.5%

0.3461

0.3649

0.3828

0.3999

0.4163

0.4321

725

0.3451

0.3761

0.4046

0.4307

0.4559

0.4799

750

0.3455

0.3746

0.4018

0.4271

0.4515

0.4748

775

0.3454

0.3732

0.3993

0.4241

0.4475

0.4701

800

0.3452

0.3724

0.3977

0.4214

0.4442

0.4660

825

0.3452

0.3715

0.3962

0.4193

0.4415

0.4629

850

0.3453

0.3709

0.3947

0.4175

0.4395

0.4604

875

0.3453

0.3701

0.3935

0.4159

0.4372

0.4578

900

0.3453

0.3696

0.3925

0.4142

0.4352

0.4555

925

0.3454

0.3689

0.3914

0.4131

0.4337

0.4537

950

0.3450

0.3682

0.3907

0.4120

0.4325

0.4522

975

0.3447

0.3679

0.3901

0.4110

0.4313

0.4506

1000

0.3450

0.3676

0.3892

0.4101

0.4303

0.4497

1025

0.3448

0.3672

0.3888

0.4094

0.4293

0.4484

1050

0.3445

0.3667

0.3881

0.4084

0.4281

0.4472

1075

0.3440

0.3663

0.3876

0.4078

0.4273

0.4461

1100

0.3441

0.3660

0.3871

0.4070

0.4263

0.4449

725

0.3629

0.3949

0.4257

0.4552

0.4834

0.5107

750

0.3595

0.3894

0.4180

0.4452

0.4712

0.4966

775

0.3559

0.3844

0.4112

0.4369

0.4614

0.4852

800

0.3526

0.3795

0.4053

0.4298

0.4533

0.4760

825

0.3495

0.3756

0.4002

0.4237

0.4463

0.4683

850

0.3465

0.3721

0.3960

0.4188

0.4406

0.4616

875

0.3436

0.3685

0.3917

0.4139

0.4349

0.4554

900

0.3408

0.3648

0.3876

0.4097

0.4303

0.4502

925

0.3379

0.3617

0.3841

0.4057

0.4258

0.4454

950

0.3350

0.3583

0.3805

0.4015

0.4213

0.4404

975

0.3319

0.3549

0.3767

0.3972

0.4168

0.4359

1000

0.3293

0.3520

0.3734

0.3938

0.4133

0.4320

1025

0.3265

0.3491

0.3701

0.3900

0.4092

0.4276

1050

0.3236

0.3460

0.3668

0.3867

0.4056

0.4238

1075

0.3214

0.3435

0.3643

0.3838

0.4027

0.4206

1100

0.3182

0.3404

0.3610

0.3806

0.3992

0.4170

Leland

EV1

EV2

Cost

11

Leland Model

Hedging Volatility

Hedging Volatility

BSM Model

1
0

1
1500

0.5
0.45
0.4
0.35
1500

0.015

1000
Strike Prices

500

1000

0.01
0.005
Transaction Costs

Strike Prices

EV2 Model

0.5

Hedging Volatility

Hedging Volatility

EV1 Model

500

0.015
0.01
0.005
Transaction Costs

0.45
0.4
0.35

0.6

0.4

0.2
1500

1500
1000
Strike Prices

500

0.015
0.01
0.005
Transaction Costs

1000
Strike Prices

500

0.015
0.01
0.005
Transaction Costs

Figure 1. Hedging Volatilities for Alternative Models

The Leland hedging volatility does not depend on the strike price. As the strike price
increases, the volatility decreases for the endogenous models. The changing volatility
with changing strikes is greater for the EV2 model than the EV1 model. Also, the
volatility skewness is more pronounced for all levels of transaction cost with the EV2
model than with the EV1. This suggests that the option prices with the endogenous
method EV2 should be closer to actual prices.

3.2. Predicted Option Prices

In Table II, the actual option prices at various strike levels are compared to the model
prices at strike levels and transaction cost levels. For each model the prices which are
closest to the actual price are in bold.
There are several observations we can make based on the presented prices in Table
II and Figure 2. Within each model, the best price for in-the-money options is at the
high transaction cost level. In fact, as the strike price increases, the transaction cost
12

Table II: Predicted Option Prices by Model

Model

Leland

EV1

EV2

Strike
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100

Actual
212.10
193.95
176.55
159.90
144.00
128.75
114.65
100.90
88.55
76.85
66.20
56.50
47.75
40.00
33.20
27.20
212.10
193.95
176.55
159.90
144.00
128.75
114.65
100.90
88.55
76.85
66.20
56.50
47.75
40.00
33.20
27.20
212.10
193.95
176.55
159.90
144.00
128.75
114.65
100.90
88.55
76.85
66.20
56.50
47.75
40.00
33.20
27.20

0%
183.28
164.92
147.72
131.72
116.94
103.38
91.01
79.81
69.72
60.69
52.64
45.51
39.22
33.70
28.88
24.68
183.12
164.82
147.584
131.53
116.74
103.21
90.82
79.63
69.56
60.42
52.31
45.25
38.93
33.36
28.47
24.31
186.00
167.35
149.69
133.12
117.73
103.49
90.39
78.49
67.70
57.96
49.24
41.64
34.91
29.01
24.08
19.66

0.3%
186.34
168.36
151.50
135.79
121.26
107.88
95.64
84.50
74.41
65.33
57.18
49.91
43.45
37.73
32.68
28.25
188.22
170.16
153.188
137.42
122.77
109.31
96.92
85.66
75.42
66.15
57.90
50.56
43.98
38.12
32.98
28.47
191.41
172.93
155.46
138.97
123.71
109.59
96.52
84.47
73.61
63.71
54.76
46.89
39.90
33.68
28.36
23.62

13

Cost
0.6%
189.34
171.69
155.14
139.69
125.37
112.16
100.03
88.95
78.87
69.75
61.52
54.14
47.53
41.64
36.40
31.77
193.10
175.29
158.529
142.97
128.46
115.01
102.65
91.36
81.02
71.70
63.30
55.67
48.91
42.81
37.42
32.63
196.82
178.40
160.99
144.63
129.37
115.31
102.20
90.13
79.19
69.17
60.04
51.90
44.63
38.14
32.55
27.49

0.9%
192.28
174.93
158.65
143.44
129.31
116.25
104.22
93.19
83.13
73.98
65.69
58.21
51.48
45.44
40.04
35.23
197.72
180.19
163.669
148.18
133.80
120.45
108.14
96.74
86.42
76.99
68.40
60.65
53.69
47.36
41.75
36.70
202.16
183.73
166.36
150.04
134.80
120.77
107.64
95.61
84.57
74.36
65.03
56.74
49.18
42.49
36.61
31.32

1.2%
195.15
178.08
162.05
147.05
133.10
120.17
108.24
97.26
87.22
78.05
69.71
62.14
55.31
49.14
43.60
38.62
202.29
184.96
168.58
153.23
138.94
125.72
113.35
101.94
91.56
82.06
73.38
65.52
58.37
51.83
46.01
40.73
207.37
188.87
171.51
155.26
140.04
125.99
112.79
100.73
89.59
79.28
69.84
61.42
53.65
46.72
40.64
35.09

1.5%
197.96
181.15
165.34
150.54
136.75
123.94
112.10
101.18
91.15
81.97
73.58
65.95
59.02
52.74
47.07
41.96
206.72
189.60
173.35
158.08
143.89
130.71
118.38
106.99
96.54
86.96
78.16
70.24
62.89
56.23
50.20
44.72
212.54
193.96
176.57
160.30
145.14
131.00
117.81
105.68
94.47
84.04
74.52
65.93
57.97
50.84
44.54
38.77

BSM Model

Leland Model

200
Predicted Prices

Predicted Prices

200

100

0
1500

100

0
1500

0.015

1000
Strike Prices

500

1000

0.01
0.005
Transaction Costs

Strike Prices

EV1 Model

EV2 Model

300
Predicted Prices

300
Predicted Prices

500

0.015
0.01
0.005
Transaction Costs

200
100

0
1500

200
100

0
1500

1000
Strike Prices

500

0.015
0.01
0.005
Transaction Costs

1000
Strike Prices

500

0.015
0.01
0.005
Transaction Costs

Figure 2. Predicted Prices for Various Models

for the best matched price decreases. For almost all strike prices, the closest model
price is produced by the EV2 model for some transaction cost level.The options prices
from the EV2 model are very accurate for in-the-money options. For each of the deeply
in- or out-of-the-money options there exists a transaction cost level such that the EV2
model price is closest to the actual price, as bolded prices in the table indicate.

3.3. Hedging Error

Realized Error. The estimation error with the option price is a factor in the performance of the hedging portfolio. The portfolio performance for the period of the data
based on option prices from the various models is provided in Table III, in which the
error is the difference between the portfolio value and the option payoff.
As expected the superiority of the EV2 model occurs for deeply in- or out-of-themoney options for some transaction cost level, where the predicted option prices were
closer to actual option prices. In the presence of transaction costs, we propose that
14

Table III: Realized Errors for the Various Models

Model

BSM

Leland

EV1

EV2

Strike
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100

Cost
0%
22.5076
23.4656
24.5768
25.8243
27.2804
29.2287
33.1912
39.0564
42.5350
33.2905
26.9386
20.9479
15.3613
10.7064
7.1018
4.3057
22.5076
23.4656
24.5768
25.8243
27.2804
29.2287
33.1912
39.0564
42.5350
33.2905
26.9386
20.9479
15.3613
10.7064
7.1018
4.3057
22.4737
23.4427
24.5422
25.7722
27.2218
29.1688
33.1130
38.9719
42.4621
33.2117
26.8911
20.9411
15.3874
10.7787
7.2348
4.4629
23.0339
23.9992
25.0496
26.1889
27.5078
29.2652
32.9434
38.4696
41.6664
32.5135
26.4853
20.9214
15.8749
11.8874
8.9112
6.7489

0.3%
16.6535
17.1585
17.8350
18.6799
19.7815
21.4312
25.1650
31.2463
35.3584
26.9553
21.5411
16.4414
11.6266
7.6393
4.5916
2.2485
17.3185
18.0064
18.8555
19.8748
21.1794
23.1092
27.1816
33.4957
37.5091
28.4193
22.2825
16.6096
11.2853
6.8227
3.3705
0.7310
17.6824
18.4089
19.2740
20.3186
21.6439
23.6207
27.7227
34.0349
37.9574
28.6778
22.4082
16.6487
11.2596
6.7591
3.2901
0.6481
18.2398
18.9788
19.8070
20.7286
21.9278
23.7231
27.5547
33.4842
37.1496
27.9060
21.8731
16.4740
11.5550
7.6444
4.7819
2.7567

0.6%
10.7993
10.8515
11.0932
11.5356
12.2826
13.6337
17.1387
23.4363
28.1818
20.6202
16.1435
11.9349
7.8920
4.5721
2.0813
0.1913
12.1842
12.6324
13.2548
14.0846
15.2741
17.2065
21.4014
28.1752
32.6753
23.7313
17.7660
12.3621
7.2711
2.9879
-0.3231
-2.8245
12.8881
13.4228
14.1002
15.0034
16.2623
18.2814
22.5619
29.3454
33.6717
24.3989
18.1300
12.5023
7.2508
2.8425
-0.5613
-3.1148
13.4942
14.0360
14.6680
15.4459
16.5486
18.3945
22.3688
28.7553
32.8233
23.5343
17.4686
12.1872
7.3830
3.5492
0.7577
-1.1475

15

0.9%
4.9451
4.5444
4.3514
4.3912
4.7837
5.8362
9.1125
15.6263
21.0053
14.2850
10.7460
7.4284
4.1574
1.5050
-0.4289
-1.8659
7.1064
7.3402
7.7647
8.4359
9.5382
11.4878
15.8197
23.0584
28.0054
19.2008
13.3758
8.2014
3.3183
-0.7976
-3.9764
-6.3539
8.1075
8.4886
9.0297
9.8002
11.0324
13.1426
17.6275
24.8440
29.5824
20.2977
14.0016
8.4926
3.3534
-0.9707
-4.3119
-6.7915
8.7993
9.1699
9.6470
10.3054
11.3554
13.2655
17.4011
24.2852
28.7018
19.3407
13.2248
8.0430
3.3314
-0.4359
-3.1533
-4.9883

1.2%
-0.9091
-1.7626
-2.3904
-2.7532
-2.7152
-1.9614
1.0862
7.8163
13.8287
7.9498
5.3485
2.9219
0.4228
-1.5621
-2.9392
-3.9231
2.0849
2.1257
2.3763
2.9140
3.9507
5.9282
10.4125
18.1166
23.4773
14.8073
9.0997
4.1229
-0.5744
-4.5346
-7.5888
-9.8531
3.3890
3.6329
4.0470
4.7411
5.9642
8.1903
12.8521
20.5395
25.6122
16.3449
10.0332
4.6081
-0.4413
-4.6931
-7.9801
-10.4032
4.1593
4.3763
4.7232
5.2987
6.3243
8.2966
12.5957
19.9256
24.6590
15.2839
9.1324
4.0253
-0.6139
-4.3187
-6.9899
-8.7516

1.5%
-6.76322
-8.06976
-9.13213
-9.89758
-10.21415
-9.75894
-6.94007
0.00638
6.65216
1.61473
-0.04916
-1.58460
-3.31194
-4.62927
-5.44948
-5.98030
-2.8814
-3.0154
-2.9184
-2.4936
-1.5058
0.5081
5.1600
13.3272
19.0731
10.5340
4.9268
0.1214
-4.4092
-8.2242
-11.1607
-13.3205
-1.2812
-1.1493
-0.8364
-0.2089
1.0276
3.3498
8.2443
16.4045
21.7803
12.5262
6.1798
0.8323
-4.1468
-8.3319
-11.5706
-13.9520
-0.4118
-0.3236
-0.0901
0.4110
1.4482
3.4688
7.9738
15.7290
20.7609
11.3684
5.1825
0.1186
-4.4619
-8.1123
-10.7338
-12.4411

investors view gains and losses from a hedging portfolio differently depending on the
moneyness of the option.
The performance of the hedging portfolio depends on the hedging volatility and
corresponding option price. The hedging volatility depends on the criteria for performance of the hedging portfolio. The results by the alternative performance criteria
are considered separately.
Hedging Error by Mean Absolute Deviation. The values for the mean absolute deviation criterion are illustrated in Figure 3 and Table IV. Those results by
strike price and transaction cost show that the EV1 is the best model for this criterion,
and also how far the other models are from the optimum.
BSM Model

Leland Model

6
Hedging Error

Hedging Error

20

10

0
1500

4
2

0
1500
1000

Strike Prices

500

0.015
0.01
0.005
Transaction Costs

1000
Strike Prices

EV1 Model

EV2 Model

5
Hedging Error

4
Hedging Error

500

0.015
0.01
0.005
Transaction Costs

3
2

1
1500

4
3

2
1500
1000

Strike Prices

500

0.015
0.01
0.005
Transaction Costs

1000
Strike Prices

500

0.015
0.01
0.005
Transaction Costs

Figure 3. Hedging Error by Mean-Absolute Deviation for Alternative Models

For the mean absolute deviation criterion the values for the Leland, EV1 and EV2
models are close, and very close in the mid-range of strikes. The errors increase in
transaction cost for each model. However, the pattern with strikes differs for the
models. Leland and EV1 have a hill pattern, whereas the EV2 has a valley shape. So
16

Table IV: Hedging Errors by Mean-Absolute Deviation

Model

BSM

Leland

EV1

EV2

Strike
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100

0%
1.6407
1.8288
1.9962
2.1342
2.2536
2.3513
2.4198
2.4438
2.4463
2.4216
2.4000
2.3416
2.2814
2.1930
2.0688
1.9534
1.6407
1.8288
1.9962
2.1342
2.2536
2.3513
2.4198
2.4438
2.4463
2.4216
2.4000
2.3416
2.2814
2.1930
2.0688
1.9534
1.6394
1.8283
1.9953
2.1329
2.2522
2.3502
2.4186
2.4423
2.4453
2.4189
2.3971
2.3387
2.2783
2.1883
2.0627
1.9480
2.0216
2.1075
2.1739
2.2249
2.2858
2.3529
2.4248
2.4854
2.5573
2.6184
2.7077
2.7635
2.8203
2.8468
2.7970
2.7927

0.3%
2.8783
3.0946
3.2653
3.3941
3.5033
3.5721
3.6061
3.5846
3.5480
3.4604
3.3612
3.2474
3.1142
2.9503
2.7713
2.5938
2.0093
2.1467
2.2600
2.3564
2.4435
2.5172
2.5676
2.5787
2.5693
2.5323
2.5028
2.4411
2.3788
2.2869
2.1616
2.0449
1.8520
2.0033
2.1415
2.2585
2.3612
2.4485
2.5110
2.5351
2.5335
2.5084
2.4862
2.4269
2.3684
2.2817
2.1589
2.0432
2.2873
2.3128
2.3407
2.3515
2.3929
2.4511
2.5168
2.5805
2.6456
2.7117
2.8076
2.8694
2.9219
2.9566
2.9290
2.9210

0.6%
5.2932
5.6181
5.8775
6.0694
6.2089
6.2853
6.2789
6.2010
6.0840
5.9030
5.6764
5.4382
5.1566
4.8513
4.5351
4.2062
2.7585
2.8142
2.8429
2.8672
2.8844
2.9008
2.8984
2.8702
2.8300
2.7636
2.7077
2.6266
2.5471
2.4430
2.3080
2.1834
2.2112
2.3118
2.4051
2.4843
2.5574
2.6228
2.6727
2.6838
2.6694
2.6384
2.6100
2.5460
2.4842
2.3960
2.2736
2.1558
2.7415
2.6716
2.6232
2.5901
2.5902
2.6257
2.6789
2.7323
2.7881
2.8471
2.9422
3.0132
3.0752
3.1151
3.0835
3.0869

17

Cost
0.9%
7.9109
8.3779
8.7624
9.0506
9.2459
9.3471
9.3332
9.2172
9.0369
8.7616
8.4209
8.0507
7.6231
7.1602
6.6742
6.1805
3.6462
3.6286
3.5828
3.5286
3.4728
3.4241
3.3609
3.2813
3.1995
3.0891
2.9935
2.8849
2.7790
2.6515
2.5000
2.3591
2.6188
2.6736
2.7240
2.7629
2.8069
2.8454
2.8756
2.8716
2.8429
2.7993
2.7595
2.6872
2.6195
2.5268
2.4029
2.2828
3.2578
3.0884
2.9690
2.8817
2.8419
2.8487
2.8839
2.9156
2.9573
3.0209
3.1186
3.1771
3.2584
3.2900
3.2730
3.2646

1.2%
10.5519
11.1687
11.6789
12.0672
12.3277
12.4600
12.4482
12.2993
12.0576
11.6950
11.2447
10.7424
10.1681
9.5483
8.8971
8.2363
4.5909
4.5098
4.3947
4.2714
4.1492
4.0320
3.9090
3.7692
3.6392
3.4809
3.3412
3.1949
3.0594
2.9062
2.7327
2.5706
3.0467
3.0598
3.0723
3.0747
3.0880
3.0993
3.1097
3.0892
3.0417
2.9826
2.9308
2.8486
2.7711
2.6715
2.5442
2.4193
3.7860
3.5213
3.3399
3.2057
3.1283
3.1021
3.1182
3.1372
3.1701
3.2269
3.3132
3.3591
3.4432
3.4834
3.4580
3.4609

1.5%
13.1938
13.9605
14.5989
15.0854
15.4115
15.5777
15.5667
15.3873
15.0861
14.6363
14.0739
13.4402
12.7212
11.9454
11.1307
10.3026
5.5668
5.4269
5.2487
5.0598
4.8748
4.6940
4.5103
4.3114
4.1294
3.9214
3.7377
3.5516
3.3782
3.1964
3.0002
2.8133
3.4804
3.4582
3.4353
3.4063
3.3923
3.3742
3.3622
3.3254
3.2605
3.1847
3.1190
3.0254
2.9365
2.8271
2.6943
2.5634
4.3291
3.9802
3.7325
3.5494
3.4393
3.3772
3.3711
3.3762
3.3953
3.4451
3.5133
3.5561
3.6447
3.6876
3.6668
3.6731

the errors for Leland and EV1 decrease for the extreme strikes, whereas the errors
increase for EV2 in the extremes.
Hedging Error by Option Moneyness. With the mean absolute deviation,
gains and losses are perceived the same - equally weighted. The more realistic proposition is that hedging error is perceived differently depending on the moneyness of the
option. Table V presents the weights by strike (moneyness) for the gains and losses.
When the option is deep in the money, the greater weight is on losses, while for deep
out of the money the greater weight is on gains.
Table V: Weighting probabilities
Strike
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100

Pr: Gains
0.2426
0.2880
0.3355
0.3840
0.4329
0.4814
0.5287
0.5743
0.6177
0.6586
0.6967
0.7319
0.7642
0.7935
0.8198
0.8435

1 Pr: Losses
0.7574
0.7120
0.6645
0.6160
0.5671
0.5186
0.4713
0.4257
0.3823
0.3414
0.3033
0.2681
0.2358
0.2065
0.1802
0.1565

The values for the weighted mean absolute deviation criterion are illustrated in
Figure 4 and Table VI. Those results by strike price and transaction cost show that
the EV2 is the best model for the new criterion.
In Figure 4 the pattern with strikes is somewhat changed for the Leland and EV1
models, with increasing error for deep out of the money options. The pattern for
the EV2 model is flipped, so that the errors for deep in/out of the money options in
decreased. This is exactly the effect that underlies the hedging strategy.

18

Table VI: Hedging Errors By Option Moneyness

Model

BSM

Leland

EV1

EV2

Strike
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100
725
750
775
800
825
850
875
900
925
950
975
1000
1025
1050
1075
1100

Cost
0%
1.6326
1.8294
1.9959
2.1329
2.2526
2.3508
2.4214
2.4519
2.4602
2.4443
2.4300
2.3671
2.3072
2.2194
2.0970
1.9818
1.6326
1.8294
1.9959
2.1329
2.2526
2.3508
2.4214
2.4519
2.4602
2.4443
2.4300
2.3671
2.3072
2.2194
2.0970
1.9818
1.6736
1.8500
2.0178
2.1544
2.2647
2.3531
2.4146
2.4361
2.4390
2.3980
2.3617
2.3029
2.2264
2.1136
1.9612
1.8511
1.3100
1.5897
1.8482
2.0611
2.2320
2.3505
2.4085
2.3950
2.3325
2.2085
2.0688
1.8934
1.7101
1.5034
1.3007
1.1130

0.3%
4.2301
4.2786
4.2257
4.0928
3.9159
3.6877
3.4287
3.1337
2.8486
2.5499
2.2776
2.0209
1.7906
1.5692
1.3698
1.2009
2.5594
2.5855
2.5823
2.5692
2.5584
2.5467
2.5265
2.4848
2.4351
2.3732
2.3290
2.2507
2.1840
2.0942
1.9774
1.8709
1.9122
2.0516
2.1790
2.2781
2.3718
2.4508
2.5075
2.5295
2.5201
2.4813
2.4551
2.3875
2.3129
2.2030
2.0670
1.9435
1.5115
1.7603
1.9936
2.1857
2.3385
2.4479
2.5015
2.4848
2.4153
2.2902
2.1484
1.9685
1.7788
1.5692
1.3625
1.1687

0.6%
8.0050
7.9856
7.7988
7.4680
7.0351
6.5170
5.9224
5.2912
4.6715
4.0593
3.4793
2.9596
2.4836
2.0629
1.7039
1.3921
3.8621
3.6881
3.4859
3.2933
3.1148
2.9603
2.8142
2.6733
2.5454
2.4190
2.3245
2.2129
2.1223
2.0199
1.8985
1.7928
2.3184
2.3935
2.4655
2.5127
2.5711
2.6267
2.6672
2.6741
2.6483
2.6150
2.5872
2.4970
2.4317
2.3195
2.1901
2.0596
1.8609
2.0685
2.2607
2.4168
2.5390
2.6236
2.6602
2.6275
2.5423
2.4078
2.2560
2.0651
1.8656
1.6490
1.4336
1.2326

19

0.9%
11.9826
11.9288
11.6445
11.1491
10.4856
9.6948
8.7976
7.8484
6.9112
5.9848
5.1102
4.3201
3.6007
2.9643
2.4132
1.9453
5.2996
4.9351
4.5449
4.1673
3.8188
3.5136
3.2335
2.9804
2.7626
2.5557
2.3962
2.2412
2.1159
1.9883
1.8538
1.7391
2.8114
2.8069
2.8096
2.8166
2.8316
2.8513
2.8683
2.8518
2.8177
2.7709
2.7220
2.6344
2.5592
2.4415
2.3099
2.1683
2.2589
2.4319
2.5856
2.7047
2.7942
2.8482
2.8613
2.8067
2.7006
2.5516
2.3835
2.1767
1.9658
1.7382
1.5125
1.3025

1.2%
15.9835
15.9031
15.5219
14.8656
13.9810
12.9237
11.7335
10.4715
9.2186
7.9849
6.8205
5.7597
4.7963
3.9450
3.2065
2.5798
6.7912
6.2468
5.6749
5.1222
4.6107
4.1517
3.7380
3.3635
3.0483
2.7558
2.5255
2.3157
2.1510
1.9943
1.8401
1.7102
3.3067
3.2405
3.1947
3.1496
3.1237
3.1065
3.0984
3.0607
3.0030
2.9418
2.8873
2.7968
2.7118
2.5770
2.4407
2.2869
2.6677
2.8189
2.9429
3.0261
3.0842
3.1039
3.0896
3.0113
2.8820
2.7127
2.5250
2.3006
2.0747
1.8334
1.5969
1.3761

1.5%
19.9853
19.8784
19.4027
18.5837
17.4783
16.1575
14.6731
13.1006
11.5340
9.9930
8.5361
7.2054
6.0000
4.9346
4.0104
3.2250
8.3115
7.5930
6.8462
6.1225
5.4520
4.8439
4.2956
3.8001
3.3829
3.0021
2.6999
2.4317
2.2181
2.0283
1.8522
1.7025
3.8198
3.6882
3.5939
3.5085
3.4414
3.3849
3.3466
3.2895
3.2099
3.1290
3.0553
2.9707
2.8603
2.7307
2.5795
2.4172
3.0744
3.2134
3.3143
3.3695
3.3958
3.3818
3.3375
3.2334
3.0784
2.8850
2.6760
2.4317
2.1900
1.9344
1.6846
1.4523

BSM Model

Leland Model

10
Hedging Error

Hedging Error

20

10

0
1500

0
1500
0.015

1000
Strike Prices

500

0.01
0.005
Transaction Costs

1000
Strike Prices

EV1 Model

EV2 Model

4
Hedging Error

4
Hedging Error

500

0.015
0.01
0.005
Transaction Costs

3
2

1
1500

3
2

1
1500
1000

Strike Prices

500

0.015
0.01
0.005
Transaction Costs

1000
Strike Prices

500

0.015
0.01
0.005
Transaction Costs

Figure 4. Hedging Error by Option Moneyness for Alternative Models

4. Conclusion
In the last thirty years, financial derivatives have grown from a marginal activity
to occupy center-stage position in financial economic theory and financial practice.
At the same time, mathematical finance has grown to be one of the main branches
of applied mathematics. The single largest credit for these remarkable developments
are due to Fisher Black, Myron Scholes, and Robert Merton, whos classic 1973 papers
gave a theory of how to price options. Without this prescription, option pricing would
have remained more of an art than a science, and trading in options would have been
less liquid and less important, as traders would have had a less firm idea on how
to fairly value and hedge the options. However, this great achievement rests on the
assumptions of no arbitrage, lognormality for spot price dynamics, and frictionless
trading. In reality, even though the condition of arbitrage free and the assumption of
lognormality are arguably to be satisfactory most of the time, transaction costs always
exist. As well the evidence suggests that the option price depends on the moneyness
20

of the option, that is the strike price.

In this paper a pricing method is introduced which links the volatility to both
the transaction cost and the strike price. The Black-Scholes-Merton formula is used,
with the endogenous volatility, to price options. The results are clear. The endogenous volatility approach produces more accurate prices. The optimization problem
for calculating the endogenous volatilities is simple to implement so that using the
approach is practical.

21

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