Perfect hedging under endogenous permanent market impacts (Q1709607)

This paper deals with a hedging problem under model which captures endogenously such phenomena as nonlinearity in liquidation, permanent market impact and market crashes. The authors model a nonlinear price curve quoted in a market as the utility indifference curve of a representative liquidity supplier. \(g\)-expectation is adopted as the utility function. In presented model a trader is no longer a price taker as any trade has a permanent market impact via an effect on the supplier's inventory. The authors consider the profit and loss of trading strategy as a nonlinear stochastic integral. A completeness condition under which any derivative can be perfectly replicated by a dynamic trading strategy is presented. For the Markovian case the authors consider a class of models which admit explicit computations and verify the obtained conditions. The hedging of European options and discussion how the model captures illiquidity phenomena are presented.