Difference between revisions of "Replicating Portfolio"

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(Created page with "In Principles of Corporate Finance a replicating portfolio is defined as the combination of: * Borrowing money * Buying a ratio of stock Su...")
 
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In [[Principles of Corporate Finance|Principles of Corporate Finance]] a replicating portfolio is defined as the combination of:
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Replicating Portfolio
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* Borrowing money
 
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* Buying a ratio of stock
 
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Such that you replicate exactly the payoff from one call option. The number of shares need to replicate one call is called the ''option delta'' or ''hedge ratio''.
 
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Take the example of a stock with has a current stock price of \$80,- with a maximum downside potential of 25% drop and an upside of 33% increase. This means that the stock can move between
 
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* \$60,-
 
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* \$106,67,-
 
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A call option for \$80,- in this case would be moving between:
 
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* \$0,- (in the case there the stock price was below \$80,-)
 
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* Between \$0,- and \$26,67 if the stock price was moving between and  \$106,67,-
 
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* \$26,67 (in the case the stock price was exactly \$106,67,-)
 
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How should we value such a call option? There are two methods of calculation:
 
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=Calculate option delta=
 
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The option delta can be calculate as follows:
 
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<math>\text{Option delta}</math> = <math>\frac{\text{Spread of option prices}}{\text{Spread of share prices}}</math>=<math>\frac{26.67 - 0}{106.67 - 60}</math>=<math>\frac{26.67}{46.67}</math>=<math>\frac{4}{7}</math>
 
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<math>\frac{80 - ((4/7) \cdot 80)}{1.025}</math>= <math>33.45</math>
 
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A more intuitive way of calculating the amount of money that needs to be borrowed is to simply subtract
 
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The value of the call is then:
 
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<math>\text{Value of call}</math> = <math>\text{Value of (4/7) shares}</math> -  <math>\text{33.45 bank loan}</math> =
 
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= <math>80 \cdot (4/7) - 33.45</math>  =  <math>12.26</math>
 
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=Risk Neutral Valuation=
 
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{{:Risk-Neutral Valuation}}
 
 
[[Category:finance]]
 
[[Category:finance]]
  

Revision as of 18:39, 27 August 2020

Replicating Portfolio