Hedging with Temporary Price Impact

Abstract: We consider the problem of hedging a European contingent claim in a Bachelier model with transient price impact as proposed by Almgren and Chriss. Following the approach of Rogers and Singh and Naujokat and Westray, the hedging problem can be regarded as a cost optimal tracking problem of the frictionless hedging strategy. We solve this problem explicitly for general predictable target hedging strategies. It turns out that, rather than towards the current target position, the optimal policy trades towards a weighted average of expected future target positions. This generalizes an observation of Garleanu and Pedersen from their homogenous Markovian optimal investment problem to a general hedging problem. Our findings complement a number of previous studies in the literature on optimal strategies in illiquid markets where the frictionless strategy is confined to diffusions. The consideration of general predictable reference strategies is made possible by the use of a convex analysis approach instead of the more common dynamic programming methods.