On option pricing in binomial market with transaction costs

Option replication is studied in a discrete-time framework with proportional transaction costs. The model represents an extension of the Cox-Ross-Rubinstein binomial option-pricing model to cover the case of proportional transaction costs for one risky asset with different interest rates on bank credit and deposit. Contingent claims are supposed to be 2-dimensional random variables. Explicit formulas for self-financing strategies are obtained for this case.Received: March 2004, Mathematics Subject Classification (2000): 62P05JEL Classification: G11, G13The authors are grateful to an anonymous referee for numerous helpful comments and to Yulia Romaniuk for final corrections. The paper was partially supported by grant NSERC 264186.