Asymptotic replication with modified volatility under small transaction costs

Abstract

We consider the dynamic hedging of a European option under a general local volatility model with small proportional transaction costs. Extending the approach of Leland, we introduce a class of continuous strategies of finite cost that asymptotically (super-)replicate the payoff. An associated central limit theorem for the hedging error is proved. We also obtain an explicit trading strategy minimizing the asymptotic error variance.