The cornerstone of the Black-Scholes model is the possibility of hedging of any option by creating a portfolio of shares and zero coupon bonds. The Black-Scholes formula is supposed to show the weights of the components composing the portfolio. Creating such a portfolio leads to profit by continuously changing the weights of the portfolio components, if the price of the option differs from the price of underlying share or risk-free bond. This process is called dynamic hedging, and the underlying portfolio is referred to as a dynamic-replicating portfolio. The authors' goal is as follows: given a standard option with a particular strike and expiration, they would like to obtain the portfolio of other standard options with behavior similar to the original (target) option. Research suggests a formula for such a portfolio, where the target option has longer expiration and the basis options are closer in expiration.
Practical method of static hedging Dmitriy Taubman; Gary Berg Futures; Jun 2010; 39, 6; Docstoc pg. 38 Reproduced with permission
Pages to are hidden for
"Practical method of static hedging"Please download to view full document