Here I'm considering the simple case of a dealer writing call options on a stock and hedging the short position with a "textbook" Delta Hedge, i.e. goes long on $N_c \times Delta$ stocks (where $N_c$ is the number of written calls and $Delta$ is the Delta of the options).
The value of my portfolio is given by: $$ V_t = N_c \cdot Delta_t \cdot S_t - N_c \cdot c_t = N_c ( Delta_t \cdot S_t - c_t ) $$
Assuming that nothing changes (stock price, delta, etc.) and pretending that the hedge is really effective, i.e. the portfolio is really risk-free and there is no Gamma effect or anything else that could disrupt the hedge, then this portfolio should earn the risk-free rate... Why?
I understand the arbitrage pricing principle that a hedged/riskless amount of money invested should earn the risk-free rate, but I cannot see the economic explanation.
What are the components growing at the risk-free? What is the arbitrage strategy that would force the value of a Delta hedged portfolio to drift at the risk-free rate?
Here some more thoughts on this "dilemma":
I know that $Delta_t$ and $c_t$ actually decrease with time till they go to zero at expiry of the option ceteris paribus (please, correct me if I'm wrong)... but still I don't see how this would explain any risk-free yield.
Very often, I see the argument saying that the proceeds from the short position on the calls is invested at the risk-free rate. But this cannot be the explanation, can it? Aren't my proceeds expensed in the purchase of the stocks? And second, the posit is that the whole delta hedged portfolio yields the risk-free and not just the short call proceeds.
Here I found a nice explanation by Alex C: Why/How does a hedged portfolio make profits? saying:
An Investment Bank earns a profit by selling you an option at a slightly higher price than the theoretical price, or buying it back from you at a slightly lower price. They call this "earning a spread". Then they hedge the option, so as not to make any [further] gains or losses on it (other than the risk free rate).
Another way they could earn a profit is if they have a more accurate estimate of volatility than other people have. But that is not easy to do consistently.
However this is just telling me how option writers charge me more to make a profit. It is not telling me what is the arbitrage opportunity that compels the value of that portfolio to drift at the risk-free rate.
- Where in the formula for the call price (and the Delta) do I see that there is a drift that would "magically" make a delta hedged portfolio drift at the risk-free rate?