Hedging Options in Illiquid Markets

This paper compares the theoretical price of interest rate swaps implied from the yield curve with the actual Kuala Lumpur Interbank Offer Rates used for swap resets in the Malaysian swap market for both semi-annual and annual interest rate swaps between 1996 and 2002. As far as we are aware no previous paper has considered pricing swaps in a less established derivative markets. Our empirical results indicate significant and persistent differences between the theoretical implied price and the actual reset price for both swaps over the sample period. This finding has implications for traders and banks in pricing swaps in Malaysia and more generally for pricing swaps in less established or illiquid markets or where capital controls have been introduced.

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OPTIMAL INVESTMENT ON FINITE HORIZON WITH RANDOM DISCRETE ORDER FLOW IN ILLIQUID MARKETS

International Journal of Theoretical and Applied Finance ◽

10.1142/s0219024911006243 ◽

2011 ◽

Vol 14 (01) ◽

pp. 17-40 ◽

Cited By ~ 6

Author(s):

PAUL GASSIAT ◽

HUYÊN PHAM ◽

MIHAI SÎRBU

Keyword(s):

Dynamic Programming ◽

Optimal Investment ◽

Market Model ◽

Programming Approach ◽

Order Flow ◽

Short Sale Constraints ◽

Dynamic Programming Approach ◽

Short Sale ◽

Illiquid Markets ◽

Investor Trading

We study the problem of optimal portfolio selection in an illiquid market with discrete order flow. In this market, bids and offers are not available at any time but trading occurs more frequently near a terminal horizon. The investor can observe and trade the risky asset only at exogenous random times corresponding to the order flow given by an inhomogenous Poisson process. By using a direct dynamic programming approach, we first derive and solve the fixed point dynamic programming equation satisfied by the value function, and then perform a verification argument which provides the existence and characterization of optimal trading strategies. We prove the convergence of the optimal performance, when the deterministic intensity of the order flow approaches infinity at any time, to the optimal expected utility for an investor trading continuously in a perfectly liquid market model with no-short sale constraints.

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