Vanilla Swaption Pricing with transaction costs?

florian · September 14th, 2009, 7:12 pm

Hi,For equity options with a single-signed gamma there is a simplemodification of the input implied vol in a BSM world to allow forestimating the cost when delta hedging with transaction costs, assuming the transaction costs are proportional to the underlying. (cf. PWOQF3, chapt. 48)Is something similar possible for plain vanilla swaptions?Here the input assumption might be that the swaption is hedgedwith forward starting swaps or a portfolio of swaps, and the "transactioncost" is the bid/offer of the swap rate.Thanks & cheers, Florian

florian · September 17th, 2009, 7:04 am

I would be happy with a simple fudge.Any ideas?

AhBa · November 20th, 2009, 2:32 pm

you can try this but you'll price yourself out of the market, especially if it's swaption for a major ccy. the aim is to build a portfolio large enough that when you perform portfolio hedge your transaction cost is negligible.

florian · November 21st, 2009, 10:42 am

thanks for your reply.but my question was rather how to e.g. modify black76 or do whatever similar to assess potential transaction costson a stand-alone basis in the first place, not to see whether the resulting price would be achievable in the market.(this might be the second step...)if you have an idea on this, I'll be curious.cheers, f.

AhBa · November 21st, 2009, 2:41 pm

sure. but whether this is for academic paper or for hedging of you of your own book there's not much practical use in my opinion.there's a lot of paper describing this if you google. Alternative, you make a assumption of how frequent you want to hedge out, ie twice a day, weekly etc and then take into account both bid offer and broker fees. I hope this helps

florian · November 21st, 2009, 2:55 pm

would be great if you can post a reference. never saw a paper on exactly this. (equity options yes, swaptions no)

AhBa · November 24th, 2009, 3:36 pm

hi, I don't have any paper on hand but I'm thought something for equity can be easily transformed to swaption given they're on the same principle. btw hedging is mostly likely not done via forward starting swap cause it's just too illiquid and therefore costly.