Working Paper: NBER ID: w8867
Authors: George M. Constantinides; Stylianos Perrakis
Abstract: By applying stochastic dominance arguments, upper bounds on the reservation write price of European calls and puts and lower bounds on the reservation purchase price of these derivatives are derived in the presence of proportional transaction costs incurred in trading the underlying security. The primary contribution is the derivation of bounds when intermediate trading in the underlying security is allowed over the life of the option. A tight upper bound is derived on the reservation write price of a call and a tight lower bound is derived on the reservation purchase price of a put. These results jointly impose tight upper and lower bounds on the implied volatility.
Keywords: Stochastic Dominance; Transaction Costs; Option Pricing
JEL Codes: G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Proportional transaction costs (D23) | discrepancy between observed option prices and frictionless market prices (G13) |
| Proportional transaction costs (D23) | tight upper bound on reservation write price of European call option (G13) |
| Proportional transaction costs (D23) | tight lower bound on reservation purchase price of European put option (G13) |
| Trading frequency (G14) | bounds on option prices (G13) |
| Trading frequency increases (G14) | bounds still hold (C62) |
| Stochastic volatility and stock price jumps (C58) | tighter bounds (C61) |