When Hedging Changes the Payoff: Option Replication with Price Impact and Execution Costs

Abstract

Hedging a derivative by trading the underlying asset changes the payoff that the hedging intended to replicate. We study this phenomenon when trading generates price impact and execution costs. In a binomial model, we characterize replication through a fixed-point equation. In continuous time, we derive a nonlinear pricing PDE whose implicit terminal condition captures the nature of the moving target problem of the hedger. For monotone convex Lipschitz payoffs (such as calls and puts) we establish exact replication under midpoint execution costs. Numerical experiments illustrate: (i) how price impact shifts the effective strike, (ii) the non-linear dependence of the option price on the number of contracts, (iii) how execution costs smooth terminal holdings, (iv) the extent to which the hedger's own trading can bring an otherwise worthless option into the money, and (v) we explain the spread and the shape of the limit order book in the options market based on the price impact and the shape of the limit order book of the underlying.