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THEEDGE MAL AYSIA | JUNE 18, 2012

Measuring delta in derivative portfolios

Chart 1: Cash ows for bonds and swap

Jasvin Josen

n the previous article, I explained what delta was in the market risk context and illustrated the case of a bond dealer measuring the delta in a bond portfolio. After knowing his delta exposure, he then decides how to manage the delta. In this article, I expand on the previous example by introducing interest rate swaps to hedge the delta. I then illustrate the delta measurement for options.

to $3.10.We assume that the implied volatility is 12% and the risk-free interest rate is 3%. He will see that the call option delta has a positive value while the put options delta has negative values. This is because when the underlying share price increases, the call option increases in value whereas the put options loses value. The delta of the in-the-money call seems to be o set mostly by the delta of the in-the-money put. In a net position, the traders delta position is quite small. He does not see the need to further hedge this portfolio at the moment.

Market risks apart from the delta

Bond and swap portfolio

Chart 2: Delta exposure for bonds and swap

Let us assume that the bond dealer mentioned in the previous article decides to hedge his simple three-type bond portfolio with interest rate swaps. He decides only to hedge the delta in the ve-year maturity bucket. He enters into a ve-year bullet interest rate swap (IRS) with the following terms: Five-year bullet IRS: Pay Fixed Rate: 4.4% Receive Floating Rate: 6m LIBOR + margin Notional: $50,000 The cash ows from the portfolio of bonds and the IRS will be as illustrated in Chart 1. To keep it simple, say the 6m LIBOR rate at the veyear point (obtained from the forward interest rate curve) + margin is also at 4.4%. So, at the point of entering the swap, the swap payo s just nets o to zero. Next, the dealer measures his delta exposure for the expanded portfolio.The delta prole will look like in Chart 2. We can see that his delta exposure at the veyear point is almost eliminated.This is possible with the bullet IRS where the cash ow on the oating leg also increases when the interest rate is bumped upwards. Specically, when the interest rate is bumped up by one basis point, the oating rate of the swap also changes by +0.01%, resulting in cash ow received of $2,205 (4.41% X notional of $50,000).The payout from the xed leg remains unchanged at $2,000. Putting it another way,without hedging, the dealer would su er high losses from his bonds cash ows in year 5 if interest rates increased. But with delta hedging, he makes a prot on the swap, which nearly o sets his bond losses in the ve-year maturity bucket.

The delta is often the most signicant risk that the market player must be aware of. Other risk factors that many option-like portfolios are also sensitive to are volatility (vega), interest rates used in models (rho) and gamma, the risk that the delta does not change in a linear manner.

Conclusion

We can appreciate that the measurement of delta is important for any market practitioner,whether he is a trader, market maker, fund manager or working in the treasury in a corporation. Delta measurement enables the market practitioner to know his risk and to hedge it accordingly. If he can do this prociently, he will be more condent in investing, trading and dealing in a wider range of nancial instruments and derivatives in the market. Jasvin Josen is an ex-investment banker from Europe, specialising in valuation and risk in financial derivatives. She is currently back in Malaysia, providing consultancy and training. Readers can follow her at http:// derivativetimes.blogspot.com or send their comments to Jasvin@souqmatters.com.

hedges rather than specic hedges. Here, the bond desks position will be combined with the interest rate swaps desks and the currency swaps desks portfolios to observe the net interest rate risk (or delta) exposure. Based on this net exposure, hedging of the interest rate risk is done at a macro level at the bank.

The trader denes his delta in options as the di erence in the options price when the underlying share price moves by 10 cents. He uses the Black Scholes model to compute the option price when the underlying share price moves from $3

Other market risk factors aecting the bond price

Chart 3: Option Portfolio and Delta Measurement

In measuring the delta,a price engine is involved which theoretically prices the bond. However, this assumes that the theoretical price is similar to the observed market price.This would most probably not be the case. This is because there are factors other than interest rates that cause the bond price to change.These factors include the liquidity and creditworthiness of the bond, which can also be measured.

Macro hedging

In this example, we assume that an options The practical way to hedge at trading desks of trader has three equity options on the same investment banks, however, is to conduct macro share, as shown in Chart 3:

Equity options portfolio