Pricing of foreign exchange options with transaction costs: The choice of trading interval

In this paper, we develop an arbitrage-free option valuation model in the presence of transaction costs. The model considers the trade-off between the choice of lowering costs by trading less often and the choice of reducing the hedging errors by trading more often. This trade-off allows derivation of a trading interval policy. We illustrate the model with actual transactions data and offer a procedure for the estimation of a trading interval that minimizes hedging errors and transaction costs. The findings suggest that currency options trading is most active in options with short time to expiration, especially if they are at-and out-of-the-money options.