Abstract
The research problem is how large the replication error is if an investor Delta hedges an European option over many short periods. In the project, the trinomial stock price tree is firstly built to simulate stock price changes. Then, Monte-Carlo approximation is used to put many short-period trinomial tree models together and derive the average hedging errors. The hedging errors become significantly smaller as periods involved in the trinomial tree models pass a certain number. This method can be used to create portfolios with European options.
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