Question: (Hedge a short position) In a 3-period binomial model with S0 = 4, u = 2, d = 1 2 and r = 1/4 ,

(Hedge a short position) In a 3-period binomial model with S0 = 4, u = 2, d = 1 2 and r = 1/4 , consider a lookback option with payoff V3 = max0n3{Sn} S3.

Consider the hedging formulas 0, 1, 2 to hedge the option in a short position, that is, imagine an agent who sold the lookback option for V0 and bought 0 shares of stock at time zero. At time one, she can adjust her hedging portfolio 1 and so on at time two. Verify that the portfolio value at time three match the payoff of the option.

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