Lecture 16: Delta Hedging

We are now going to look at the construction of binomial trees as

a first technique for pricing options in an approximative way.

These techniques were first proposed in:

J.C. Cox, S.A. Ross, M. Rubinstein, Option Pricing: A Simplified

Approach, Journal of Financial Economics 7 (1979), 229–264.

Reference: https://maths.ucd.ie/~vlasenko/MST30030/fm16.pdf
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Example
Suppose we want to value a European call option giving the right
to buy a stock for the strike price K = A
C 21 (the price in the
contract) in 3 months (expiry date T ). The current stock price S0
is A
C 20.

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Example
Suppose we want to value a European call option giving the right
to buy a stock for the strike price K = A
C 21 (the price in the
contract) in 3 months (expiry date T ). The current stock price S0
is A
C 20.

We make a very simplifying assumption which in reality is not

satisfied:
in 3 months the stock price will be either A
C 22 or A
C 18. We do not
know the probability for the occurrence of the stock prices A
C 22 or
A
C 18.

2 / 12
Example
Suppose we want to value a European call option giving the right
to buy a stock for the strike price K = A
C 21 (the price in the
contract) in 3 months (expiry date T ). The current stock price S0
is A
C 20.

We make a very simplifying assumption which in reality is not

satisfied:
in 3 months the stock price will be either A
C 22 or A
C 18. We do not
know the probability for the occurrence of the stock prices A
C 22 or
A
C 18.

However, at expiry date, we know the value of the option:

if the stock price goes up (to A
C 22), the payoff ST − K is AC 1;
if the stock price goes down (to AC 18), then the option is
worthless, so the value is 0.

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A portfolio with one stock and ∆ shares
Look at a portfolio which is generated at time 0 by
buying ∆ many shares of a stock (long position) and
selling one call option of the stock (short position).
If f is the price of the option the portfolio at time 0 has value
20∆ − f .

After three months the value of this portfolio can be computed:

if the stock prices moves from A
C 20 to A
C 22 then the value of the
shares is A
C 22∆ and the value of the option is AC 1, so the total
value of the portfolio is
22∆ − 1
(in this case our contract partner has the right to buy from us one
stock at the strike price A
C 21, so we have to give him AC 1);
If the stock prices moves from A C 20 to A
C 18 then the value of the
shares is A
C 18∆ and the value of the option is zero, so the total
value of the portfolio 18∆. 3 / 12