OP3 Three-period delta hedging

A short call is hedged over three periods with a stock and a bond. The stock's price is published.

Objective

Hedge the call so final wealth does not depend on where the stock goes. Graded on final wealth.

What it shows

• Delta hedging: holding enough stock that a small move in the stock changes nothing.
• A hedge that has to be adjusted as the stock moves and time passes.
• Financing the stock position, with interest at 1%.

Watch out for

• Hedging once and leaving it, in three periods that each move the stock.
• Over-hedging after a move the call does not follow.
• The stock is quoted and not negotiated, so a view cannot move it.

Who takes part

• Hedger — every student. Starts short one call, C410, at a strike of 410, which cannot be traded. Trades STOCK, at the published price, and BOND.

Class size

Any size. The stock is quoted, so each student hedges alone; only the bond depends on the class.