Quote from heech:
hlpsp,
The paper talks at length about delta-hedging. If you've looked at how Black-Scholes is derived (or at least one of the more common ways, and the only one that I truly understand)... it's by assuming an arbitrage-less environment, and by comparing an option to the cost of an equivalent "delta-hedged" portfolio.
Ie, on one hand, you have the option. On the other hand, you have an identical delta-hedged porfolio consisting of the underlying + cash. You assume the cost of the option is equivalent to the cost of synthetically replicating the option... and then calculate the latter to get the former.
So, the idea in this paper, is that this is a static-hedging alternative to the dynamically delta-hedged portfolio. But the idea is the same, this is a replication of the longer-term option.
As far as why is this useful? It talks about a scenario in the paper where longer-term options might be less liquid, therefore more expensive because of ask/bid spread if nothing else. So, instead of buying (or selling) the longer-term option, you use the more liquid near-term option. You can then roll forward after expiration, and you eventually end up saving money versus the full longer-term option. That's why I mentioned the Warren Buffet 15-year puts.
