In Problem Set 8, question 3, I ask you to show how a portfolio consisting of delta shares of ABC stock and a long position in 1 put option can be made riskless at the very beginning of the binomial tree and also at nodes u and d. I also ask you to show that the riskless hedge portfolio is guaranteed to provide an annualized return of 5% at each of these nodes.
These concepts are illustrated by a document on the course website entitled ?Delta Hedging Interpretations of two-period European Call and Put Options? (see http://fin4335.garven.com/fall2012/deltahedging_calls&puts.pdf). This document shows how one can create riskless hedge portfolios using either short calls or long puts along with long positions involving delta shares of the underlying, and it also shows that these portfolios yield the riskless rate of return. The numerical examples provided there are based upon pages 6-7 of the lecture note located at http://fin4335.garven.com/fall2012/lecture16.pdf; also see the spreadsheet located at http://fin4335.garven.com/fall2012/binomial%20option%20model.xls.
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