Option pricing and replication with transaction costs and dividends

This paper derives optimal perfect hedging portfolios in the presence of tr ansaction costs within the binomial model of stock returns, for a market ma ker that establishes bid and ask prices for American call options on stocks paying dividends prior to expiration. It is shown that, while the option h older's optimal exercise policy at the ex-dividend date varies according to the stock price, there are intervals of values for such a price where the optimal policy would depend on the holder's preferences. Nonetheless, the p erfect hedging assumption still allows the derivation of optimal hedging po rtfolios for both long and short positions of a market maker on the option. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: G1 3.