1 Calculation of Improved Delta

We have the following expansion for the change in St over the interval [t, t + δt]
√
 
1 1
δS = σφS δt + µ − σ 2 + σ 2 φ2 Sδt
2 2
  (1)
1 1 3
+ µ − σ 2 φ + σ 2 φ3 σSδt 2 + O δt2


2 6
and hence
 
1 2 1 2 2 3
2 2 2 2
δS = σ φ S δt + 2σφ µ − σ + σ φ S 2 δt 2 + O δt2


(2)
2 2
3 3 3 3 32 2


δS = σ φ S δt + O δt (3)

Similarly, expanding V (t, St ) over the interval [t, t + δt] gives

1 1 1
δV = Vt δt + Vx δS + Vxx δS 2 + Vtx δtδS + Vtt δt2 + Vxxx δS 3 + · · ·
√ 2 2 6
= σφSVx δt
   
1 2 1 2 2 1 2 2 2
+ Vt + µ − σ + σ φ SVx + σ φ S Vxx δt
2 2 2 (4)
    
1 2 1 2 3 1 2 1 2 2
+ σ µ − σ φ + σ φ SVx + σφ µ − σ + σ φ S 2 Vxx
2 6 2 2

1 3
+ σφSVtx + σ 3 φ3 S 3 Vxxx δt 2 + O δt2


6
We can then write
δΠ = δV − ∆δS
√ 3 (5)
= A(∆, φ) δt + B(∆, φ)δt + C(∆, φ)δt 2 + O δt2

where

A(∆, φ) = σφ(Vx − ∆)S

1 1 1
B(∆, φ) = Vt + µSVx − σ 2 SVx + σ 2 φ2 SVx + σ 2 φ2 S 2 Vxx
 2  2 2
1 2 1 2 2
− µ − σ + σ φ ∆S
2 2

1 1
C(∆, φ) = σS µVx − σ 2 φVx + σ 2 φ3 Vx + µφSVxx
2 6

1 2 1 2 3 1 2 3 2
− σ φSVxx + σ φ SVxx + φVtx + σ φ S Vxxx
2 2 6
 
1 1
− σ∆S µ − σ 2 φ + σ 2 φ3
2 6
We then have
3
δΠ2 = A(∆, φ)2 δt + 2A(∆, φ)B(∆, φ)δt 2
5

(6)
+ B(∆, φ)2 + 2A(∆, φ)C(∆, φ) δt2 + O δt 2

1
Now, using the fact that

E [φ] = 0, E φ2 = 1, E φ3 = 0 and E φ4 = 3
     
(7)

and from the Black Scholes PDE

∂
Vtx = Vt
∂x  
∂ 1 2 2
= rV − rxVx − σ x Vxx (8)
∂x 2
1
2
= −rxVxx − σ xVxx − σ 2 x2 Vxxx
2
we obtain the following

E δΠ2 = σ 2 (Vx − ∆)2 S 2 δt

 
 
3
+ 2σ (µ − r)(Vx − ∆)S Vxx + D(∆) + D(∆)E(∆) + E(∆) δt2
2 2 2 2
4
5

+ O δt 2
(9)

where
1 1
D(∆) = Vt + µSVx − σ 2 SVx − µ∆S + σ 2 ∆S
2 2
E(∆) = σ 2 SVx + σ 2 S 2 Vxx − σ 2 ∆S

Also,
2
2 5

E [δΠ] = rV − rSVx + µ(Vx − ∆)S δt2 + O δt 2 (10)
 2 2
Now taking the partial derivative of Var [δΠ] = E δΠ − E [δΠ] w.r.t. ∆,
it is clear that we must have

∆ = Vx + ηδt (11)

where η is determined by requiring that the coefficient of δt2 in (12) below is

zero.
∂ 
Var [δΠ] 

∂∆ V +ηδt
 x    (12)
2 2 1 2 2 5

= 2σ S η − µ − r + σ SVxx δt + O δt 2
2

Therefore, the adjusted delta is given by

 
1
∆ = Vx + µ − r + σ 2 SVxx δt (13)
2