The delta hedging, replicating portfolio and risk neutral valuation perspectives for pricing options are important in that they enable us to think carefully as well as deeply concerning the economics of option pricing. For example, the delta hedging approach illustrates that an appropriately hedged portfolio consisting of either long-short call-share positions or long-long put-share positions is riskless and consequently must produce a riskless rate of return. Similarly, the replicating portfolio approach reminds us that a call option represents a “synthetic” margined stock investment, whereas a put option represents a “synthetic” short sale of the share combined with lending money. As we saw in our study of forward contracts, if there is any difference between the value of a derivative and its replicating portfolio, then one can earn profits with zero net investment and no exposure to risk. Thus, the “arbitrage-free” price for the derivative (option or forward) corresponds to the value of its replicating portfolio. The arbitrage-free pricing principle further implies that a risk-neutral valuation relationship exists between the derivative and its underlying asset, which in turn enables us to calculate risk neutral probabilities. Once we know what the risk-neutral probabilities are for up and down price movements, we can price options by discounting the risk-neutral expected value of the option payoff (i.e., its certainty-equivalent) at the riskless rate of interest.
During our next class meeting, we will extend our analysis from a single timestep to a multiple timestep setting. To do this, we need to introduce an important concept called backward induction. Backward induction involves beginning at the very end of the binomial tree and working our way back to the beginning. We’ll continue with the numerical example introduced yesterday and illustrate the backward induction method for the delta hedging, replicating portfolio and risk neutral valuation approaches. We’ll discover that multiple timesteps imply that the delta hedging and replicating portfolio methods imply “dynamic” trading strategies which require portfolio rebalancing as the price of the underlying asset changes over time.