Hi,
Can anyone explain the Interpretation of Replication of an option as a long short portfolio of shares in Black Scholes model.
Also kindly explain the dynamic rebalancing and self financing concept.
Thanks
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The two-period binomial option valuation model illustrates two important concepts, self-financing and dynamic replication. Self-financing implies that the replicating portfolio will not require any additional funds from the arbitrageur during the life of this dynamically rebalanced portfolio. If additional funds are needed, then they are financed externally.
Dynamic replication means that the payoffs from the option can
be exactly replicated through a planned trading strategy. Option valuation relies on self-financing, dynamic replication.