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I'm looking at the chapter, "The Greek Letters" in Hull's book (Options and derivatives...) and in particular the paragraph "Dynamic Aspects of Delta Hedging". He demonstrates two examples of how dynamic hedging works (within the Black-Scholes framework), for a short position on a European call option with expiry 2 weeks.

In particular, after shorting a call option, given that delta (assume that it can be computed somehow) changes over time, the seller should buy or sell stocks (might need to borrow money from some cash account) in order to neutralise the change in the value of the option due to changes in the value of the stock (delta neutral). During this hedging lifecycle, some rebalancing/hedging costs accumulate (occurring from borrowing money to buy extra stocks while hedging at discrete times) till the expiry of the option where the seller closes his position with the buyer.

Question 1:

The author claims that, if there are no transaction costs and the rebalancing is frequent, then the Discounted accumulated hedging cost at expiry (which appears as the cash remaining "to return to the bank" after having delivered the payoff and sold the owned stocks) should be equal to the Black-scholes price of the call option at inception. Anyone can (mathematically) prove why is that or provide reference?

Question 2: (for sanity)

How does a trading desk/seller knows what the delta of the option is every time they hedge the option? Do they approximate numerically using Black-Scholes? If yes, which approximation scheme of the derivative is used?

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  • $\begingroup$ Some thoughts regarding the two questions: 1) that is more or less how the Black Scholes equation is derived, so BS derivation is a way to prove this statement. 2) pricing models, which usually would not be BS, will produce the Greeks for Hedging and risk management, so the traders will use these with some element of judgment. $\endgroup$ – Magic is in the chain Aug 26 at 11:31
  • $\begingroup$ @ Magic is in the chain: I've thoroughly looked at the BS derivation. In Hull book's example the trader decides how much money he needs to borrow from a cash account (to buy stocks) by observing the delta at each time point. On the other hand, when one wants to build a replicating portfolio of the call option, the cash borrowed depends both on the delta and the option price at that point (see Lamberton, Intro to stoch calculus). I guess that both as in Hull's book and as by a replicating argument, the amount of cash borrowed at each time point should be equal. That I don't know how to prove... $\endgroup$ – noob-mathematician Aug 26 at 11:50

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