Understanding bid-ask spreads of derivatives under uncertain volatility and transaction costs

Abstract

The classical option valuation models assume that the option payoff can be replicated by , continuously adjusting a portfolio consisting or the underlying asset and a risk-free bond. This strategy implies a constant volatility for the underlying asset and perfect markets. However,the existence of nonzero transaction costs, the consequence of trading only at discrete in time and the random nature of volatility prevent and portfolio from being perfectly hedged continuously and hence suppress any hope of completely climinating all risks associated with derivatives