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Understanding the dual formulation for the hedging of path-dependent options with price impact

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  • Bruno Bouchard

    (CEREMADE)

  • Xiaolu Tan

Abstract

We consider a general path-dependent version of the hedging problem with price impact of Bouchard et al. (2019), in which a dual formulation for the super-hedging price is obtained by means of PDE arguments, in a Markovian setting and under strong regularity conditions. Using only probabilistic arguments, we prove, in a path-dependent setting and under weak regularity conditions, that any solution to this dual problem actually allows one to construct explicitly a perfect hedging portfolio. From a pure probabilistic point of view, our approach also allows one to exhibit solutions to a specific class of second order forward backward stochastic differential equations, in the sense of Cheridito et al. (2007). Existence of a solution to the dual optimal control problem is also addressed in particular settings. As a by-product of our arguments, we prove a version of It{\^o}'s Lemma for path-dependent functionals that are only C^{0,1} in the sense of Dupire.

Suggested Citation

  • Bruno Bouchard & Xiaolu Tan, 2019. "Understanding the dual formulation for the hedging of path-dependent options with price impact," Papers 1912.03946, arXiv.org, revised Jan 2020.
  • Handle: RePEc:arx:papers:1912.03946
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    References listed on IDEAS

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    1. Dirk Becherer & Todor Bilarev & Peter Frentrup, 2018. "Optimal liquidation under stochastic liquidity," Finance and Stochastics, Springer, vol. 22(1), pages 39-68, January.
    2. RØdiger Frey, 1998. "Perfect option hedging for a large trader," Finance and Stochastics, Springer, vol. 2(2), pages 115-141.
    3. Dirk Becherer & Todor Bilarev, 2018. "Hedging with physical or cash settlement under transient multiplicative price impact," Papers 1807.05917, arXiv.org, revised Jun 2023.
    4. Bruno Bouchard & G Loeper & Y Zou, 2017. "Hedging of covered options with linear market impact and gamma constraint," Post-Print hal-01247523, HAL.
    5. Liu, Hong & Yong, Jiongmin, 2005. "Option pricing with an illiquid underlying asset market," Journal of Economic Dynamics and Control, Elsevier, vol. 29(12), pages 2125-2156, December.
    6. Bruno Bouchard & G. Loeper & Y. Zou, 2017. "Hedging of covered options with linear market impact and gamma constraint," Post-Print hal-01611790, HAL.
    7. Umut Çetin & Robert A. Jarrow & Philip Protter, 2008. "Liquidity risk and arbitrage pricing theory," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 8, pages 153-183, World Scientific Publishing Co. Pte. Ltd..
    8. Bruno Bouchard & G Loeper & Y Zou, 2016. "Almost-sure hedging with permanent price impact," Post-Print hal-01133223, HAL.
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