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UVA-F-1432
Risk Management for Derivatives
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UVA-F-1432
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This technical note was prepared by Professor Robert M. Conroy. Copyright 2007 by the University of Virginia
Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
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RISK MANAGEMENT FOR DERIVATIVES


The Greeks are coming, the Greeks are coming!


Managing risk is important to a large number of individuals and institutions. The most
fundamental aspect of business is a process where we invest, take on risk, and in exchange earn a
compensatory return. The key to success in this process is to manage your riskreturn tradeoff.
Managing risk is a nice concept, but often difficulty arises when measuring risk. There is a
saying: What gets measured, gets managed. To alter that slightly, What cannot be measured,
cannot be managed. Hence, risk management always requires some measure of risk. Risk, in the
most general context, refers to how much the price of a security changes for a given change in
some factor.

In the context of equities, Beta is a frequently used measure of risk. Beta measures the
relative risk of an asset. High-Beta stocks, or portfolios, have more variable returns relative to
the overall market than low-Beta assets. If a Beta of 1.00 means the asset has the same risk
characteristics as the market, then a portfolio with a Beta greater than 1.00 will be more volatile
than the market portfolio and consequently more risky with higher expected returns. Conversely,
assets with a Beta less than 1.00 are less risky than average and have lower expected returns.
Portfolio managers use Beta to measure their riskreturn tradeoff. If they are willing to take on
more risk (and return), they increase the Beta of their portfolio, and if they are looking for lower
risk, they adjust the Beta of their portfolio accordingly. In a capital asset pricing model (CAPM
framework), Beta or market risk is the only relevant risk for portfolios.

For bonds, the most important source of risk is changes in interest rates. Interest rate
changes directly affect bond prices. Modified duration
1
is the most frequently used measure of
how bond prices change relative to a change in interest rates. Relatively higher modified duration
means more price volatility for a given change in interest rates. For both bonds and equities, risk
can be distilled down to a single risk factor. For bonds, it is modified duration, and for equities, it

1
For a complete discussion of duration, see Duration and Convexity, (UVA-F-1238); or R. Brealy and S.
Myers, Principles of Corporate Finance, 7
th
ed., (McGraw-Hill: Boston, 2003): 6748.
UVA-F-1432

-2-
is Beta. In each case, the risk can be measured, and then adjusted or managed to suit your risk
tolerance.

In each of those cases, financial theory provides a measure of risk. Using these risk
measures, holders of either bonds or equities can adjust or manage the risk level of the securities
that they hold. What is nice about these asset categories is that they have a single measure of
risk. Derivative securities are more challenging.


Risk Measures for Derivatives

In the discussion that follows we will define risk as the sensitivity of price to changes in
factors that affect an assets value. More price sensitivity will be interpreted as more risk.

The basic option pricing model

A simple European call option can be valued using the Black-Scholes Model
2
:

European call option value = ( ) ( )
2 1
d N e X d N UAV
T r
f




where

( ) N = Cumulative standard normal function

( )
T
T r
X
UAV
d
f

+ +
=

2
1
2
1
ln
,

T d d =
1 2
,

UAV =Underlying asset value
T = Time to maturity
= UAV volatility
X = Exercise (strike) price
r
f
= Risk-free rate

This very basic option pricing model demonstrates that the value of a European call option
depends on the value of five factors: underlying asset value, risk-free rate, volatility, time to
maturity, and exercise price. If the value of any one of those factors should change, then the
value of the option would change. Of the five inputs or factors, one is fixed (exercise price),
another is deterministic (time to maturity), and the other three change randomly over time

2
For the Black-Scholes Model, see Brealy Myers, Principles of Corporate Finance, 6027.