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    1994 Discrete Charms

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    mshchetk
    1. The document derives an expression for the change in value (δΠ) of an option portfolio over a small time interval (δt) and calculates its variance. 2. It determines that the optimal "adjusted delta" (Δ) that minimizes the variance of the portfolio value change is the option delta (Vx) plus a correction term involving the option's second derivative (Vxx), the drift (μ), and interest rate (r). 3. The key result is that the adjusted delta to use when rebalancing a delta-hedged portfolio over short time intervals is the option delta plus a term proportional to δt, where the proportionality factor depends on Vxx, μ,

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    1994 Discrete Charms

    Uploaded by

    mshchetk
    77 views2 pages
    1. The document derives an expression for the change in value (δΠ) of an option portfolio over a small time interval (δt) and calculates its variance. 2. It determines that the optimal "adjusted delta" (Δ) that minimizes the variance of the portfolio value change is the option delta (Vx) plus a correction term involving the option's second derivative (Vxx), the drift (μ), and interest rate (r). 3. The key result is that the adjusted delta to use when rebalancing a delta-hedged portfolio over short time intervals is the option delta plus a term proportional to δt, where the proportionality factor depends on Vxx, μ,

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    1. The document derives an expression for the change in value (δΠ) of an option portfolio over a small time interval (δt) and calculates its variance. 2. It determines that the optimal "adjusted delta" (Δ) that minimizes the variance of the portfolio value change is the option delta (Vx) plus a correction term involving the option's second derivative (Vxx), the drift (μ), and interest rate (r). 3. The key result is that the adjusted delta to use when rebalancing a delta-hedged portfolio over short time intervals is the option delta plus a term proportional to δt, where the proportionality factor depends on Vxx, μ,

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    77 views2 pages

    1994 Discrete Charms

    Uploaded by

    mshchetk
    1. The document derives an expression for the change in value (δΠ) of an option portfolio over a small time interval (δt) and calculates its variance. 2. It determines that the optimal "adjusted delta" (Δ) that minimizes the variance of the portfolio value change is the option delta (Vx) plus a correction term involving the option's second derivative (Vxx), the drift (μ), and interest rate (r). 3. The key result is that the adjusted delta to use when rebalancing a delta-hedged portfolio over short time intervals is the option delta plus a term proportional to δt, where the proportionality factor depends on Vxx, μ,

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 2

    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

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