Normal Approximation of the Binomial Option Price with Transaction Costs

Abstract

We consider an option pricing model with transaction costs in a discrete-time framework. European options are replicated as in the Cox-Ross-Rubinstein binomial option pricing model, reserving extra amount to cover proportional transaction costs at each trading. We construct a simple Black-Scholes type approximate pricing formula based on a higher-order approximation of the value of replicating portfolio. We compare our numerical results to Boyle and Vorst's which is based on a first-order approximation.