Hedging Options on Asset Portfolios against Just One Underlying Asset in the Presence of Transaction Costs

Abstract: Options are contingent claims regarding the value of underlying assets. The Black-Scholes formula provides a road map for pricing these options in a risk-neutral setting, justified by a delta hedging argument in which countervailing positions of appropriate size are taken in the underlying asset. However, what if an underlying asset is expensive to trade? It might be better to hedge with a different, but related asset that is cheaper to trade. This study considers this question in a setting in which the option written on a portfolio containing $\alpha$ shares of one asset $S_{t_1}$ and $(1-\alpha)$ shares of another security $S_{t_2}$ correlated with $S_{t_1}$. We suppose that the asset is hedged against only one of $S_{t_1}$ or $S_{t_2}.$ In the case of $\alpha=0~\text{or}~1$ we can consider this model to cover the case where an option on one asset is hedged against either the right" (underlying) asset or thewrong" (related, different) asset. We hedge our portfolio on simulated data using varying trading intervals, correlation coefficients, $\rho$ and transaction costs. We calculated the risk-adjusted values ($RAV$) as the risk and return measures to make meaningful decisions on when to trade $S_{t_1}$ or $S_{t_2}.$ From the conclusions made based on $RAV,$ the size of the market price of risk and that of transaction costs on both assets are key to making a decision while hedging. From our results, trading the wrong asset can be opted for when $\rho$ is very high for reasonably small transaction costs for either of the assets.