You short 100 call options (on a stock) with call premium C0 =$10 and delta-hedge each day, to the maturity date of the option at T=1 year, when the option is exercised (by L&G). The initial delta is 0.5, the strike K=100 and the current stock price is S0 =100. Next day the stock price is S1 = 100.5 and the delta is 0.55. Assume the stock price rises monotonically after you set up the delta-hedge and at T the stock price is ST =150 and your bank debt is DT =$10,025.

a) Explain the steps in the delta hedge, over the next two days, and why you end-up at T with debt (bank loan) of DT . (You may use illustrative numbers in your answer).

b) Explain how you calculate the hedging error (assuming you undertake many similar delta-hedges over the next year) and explain the source(s) of the hedging error.

(15 marks)