ON THE MEAN-VARIANCE TRADEOFF IN OPTION REPLICATION WITH TRANSACTIONSCOSTS

This paper analyzes the tradeoff between cost and risk of discretely r ebalanced option hedges in the presence of transactions costs. I prese nt closed form solutions for expected hedging error, transactions cost s, and variance of the cash flow from a time-based hedging strategy si milar to that analyzed by Leland (1985). Furthermore, I characterize t he cost and risk of a move-based hedging strategy without resorting to Monte Carlo simulations. All results are sufficiently general to acco mmodate the use of a transactions costs adjusted hedging volatility an d an asset rate of return that differs from the risk-free rate of retu rn.