Vector optimization approach for pricing and hedging in imperfect markets

The paper introduces and applies the concept of pseudo-arbitrage in order to price and hedge in imperfect financial markets, usually characterized by large transaction costs and wide bid-ask spreads. Both scalar and vector optimization problems must be used in order to implement pseudo-arbitrage. Primal problems yield strategies and hedging portfolios, while dual problems lead to transaction costs and bid-ask spread reductions, as well as optimal prices that are computed by goal programming methods. Some duality results will permit us to point out that a significant transaction costs reduction is very often feasible in practice, which is especially important for many emerging and still illiquid spot and derivative markets (electricity markets, commodity markets, markets related to weather and temperature, inflation-linked or insurance-linked derivatives, etc.).