Greeks

By A.V. Vedpuriswar

September 17, 2016

Acknowledgement
This presentation draws heavily from the work of Prof John C
Hull, an authority on Risk management.

Introduction
Greeks help us to measure the risk associated with derivative
positions.

Greeks are useful for traders.

But Greeks are not useful for the CFO/CRO to get an
aggregated view of risk.

Summary
Delta is the rate of change in value of the option portfolio with
respect to the price of the underlying asset.
Gamma is the rate of change of the portfolios delta with
respect to the price of the underlying asset.
Theta of a portfolio is the rate of change of value of the
portfolio with respect to change of time.
Vega is the rate of change of the value of the portfolio with
respect to the volatility of the underlying asset.

Rho of a portfolio of options is the rate of change of value of

the portfolio with respect to the interest rate.

Delta
Delta is the rate of change in option price with respect to the
price of the underlying asset.
It is the slope of the curve that relates the option price to the
underlying asset price.

A position with Delta of zero is called Delta neutral.

Since Delta keeps changing, the investors position may remain
delta neutral for only a relatively short period of time.

The hedge has to be adjusted periodically.

This is known as rebalancing.
The delta of a European
Scholes equation.

call option is N(d1) in the Black

The delta of a European put option is N(d1) 1 in the Black

Scholes equation.
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Gamma
The gamma is the rate of change of the portfolios delta with
respect to the price of the underlying asset.

It is the second partial derivative of the portfolio price with

respect to the asset price.
If gamma is small, it means delta is changing slowly.
So adjustments to keep a portfolio delta neutral can be made
relatively infrequently.

However, if gamma is large, the delta is highly sensitive to the

price of the underlying asst.
It is then quite risky to leave a delta neutral portfolio
unchanged for any length of time.

Theta
Theta of a portfolio is the rate of change of value of the
portfolio with respect to change of time.

Theta is also called the time decay of the portfolio.

Theta is usually negative for an option.
As time to maturity decreases with all else remaining the
same, the option loses value.

Vega
Vega is the rate of change of the value of the portfolio with
respect to the volatility of the underlying asset.

High Vega means high sensitivity to changes in volatility.

A position in the underlying asset has zero Vega.
The Vega can be changed by adding options.

To make the portfolio Gamma and Vega neutral, two traded

derivatives dependent on the underlying asset are needed.

Rho
Rho of a portfolio of options is the rate of change of value of
the portfolio with respect to the interest rate.

If interest rate increases, value of call increases. Why?

Derivatives Recap

Problem
The spot rate for a commodity is $19, the annual lease rate
5% and the risk free rate 6.5%. Calculate the 3 month forward
price.
Borrow $ 19 at 6.5% and lease out commodity at 5%.
Then outflow at the end of 3 months =
[1+(.065-.05)/4](19) = 19.071

To prevent arbitrage, 3 month forward price must be 19.071.

A forward contract has a delta of 1.

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Problem
A bank has a $ 25 million par position in a 5 year zero
coupon bond with a market value of $ 19,059,948. What is the
modified duration of the bond?
19,059,948=25,000,000/[(1+r)^5]
r = .0558

Modified duration = 5/{1 + .0558/2} = 4.86 years

The Delta in the world of derivatives is equivalent to Duration
in the world of bonds.

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Problem
An investor holds the following bonds in her portfolio. Calculate the duration.

$ 2,000,000 par value of 10 year bonds, duration of 6.95 ,price 95.5

$3,000,000 par value of 15 year bonds, duration of 9.77, price 88.6275
$ 5,000,000 par value of 30 year bonds, duration of 14.81, price 115.875

Market value of Bond 1 = 2,000,000 x .955

= 1,910,000, weight = .19

Market value of Bond 2 = 3,000,000 x .886275 = 2, 658,825, weight = .26

Market value of Bond 3 = 5,000,000 x 1.15875 = 5,793,750, weight = .56
Portfolio duration = 6.95x.19 + 9.77x .26 + 14.81x.56 = 12.15
Both Duration and Delta of a portfolio can be calculated as a weighted average
of the deltas of the individual components.

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Problem
If all the spot interest rates are increased by one basis point,
the value of a portfolio of swaps will increase by $ 1100. How
many Euro dollar futures contracts are needed to hedge the
portfolio?
A Eurodollar contract has a face value of $ 1 million and a
maturity of 3 months. If rates change by 1 basis point, the
value changes by (1,000,000) (.0001)/4= $ 25.
So the number of futures contracts needed = 1100/25=44

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Problem
A bank has sold 300,000 call options; with strike price of 50
on 100,000 shares currently trading at 49.5. How should the
bank do delta hedging?
Current delta = -.5x 300,000 + 100,000 = - 50,000
So she must buy 50,000 shares.

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Problem
Suppose an existing short option position is delta neutral and
has a gamma of 6000. Here, gamma is negative because
we have sold options. Assume there exists a traded option
with a delta of 0.6 and gamma of 1.25. Create a gamma and
delta neutral position.

Solution
To gamma hedge, we must buy 6000/1.25 = 4800 options.
Then we must sell (4800) (.6) = 2880 shares to maintain a
gamma neutral and original delta neutral position.

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Problem
A delta neutral position has a gamma of 3200. There is
an option trading with a delta of 0.5 and gamma of 1.5.
How can we generate a gamma neutral position for the
existing portfolio while maintaining a delta neutral
hedge?

Solution
Buy 3200/1.5

2133 options

Sell (2133) (.5)

1067 shares

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Problem
Suppose

a
portfolio
is
delta
= - 5000 and vega = - 8000. A traded option has
delta = 0.6. How do we achieve vega neutrality?

neutral,
with
gamma
gamma = .5, vega = 2.0 and

To achieve Vega neutrality we can add 4000 options.

Delta increases by (.6) (4000) = 2400

So we sell 2400 units of asset to maintain delta neutrality.

As the same time, Gamma changes from 5000 to
(.5) (4000) 5000 = - 3000.
If there is a second traded option with gamma = 0.8, vega = 1.2, delta = 0.5.

if w1 and w2 are the weights in the portfolio,

w1 = 400

- 5000 + 0.5w1 + 0.8w2 = 0

- 8000 + 2.0w1 + 1.2w2 = 0
w2 = 6000.

This makes the portfolio gamma and vega neutral.

But delta = (400) (.6) + (6000) (.5) = 3240
3240 units of the underlying asset will have to be sold to maintain delta neutrality.
Ref : John C Hull, Options, Futures and Other Derivatives,
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The Black Scholes Model and the Greeks (1)

For a European call option on a non dividend paying
stock, Delta = N(d1)

For Put, Delta = N(d1) -1

For a dividend paying stock,
For Call, Delta = e-qt N(d1)
For Put, Delta = e-qt [N(d1) 1]

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The Black Scholes Model and the Greeks (2)

For a European call or put option on a non dividend
paying stock,

Gamma

e d1 2 2

S 0 T 2
1

For a European call or put option on a dividend paying

stock,
2
qT d1 2
e e

Gamma
=
S 0 T 2

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Problem
Stock price = 49
Strike price = 50; Volatility = 20%
Risk free rate = 5%; Time to exercise = 20 weeks
Calculate all the option Greeks.

Using Deriva Gem spreadsheet, we get :

Call option price

= 2.40

Delta

= .522/$

Gamma

= .066/$/$

Vega

= .121/%

Theta

= -.012/day

Rho

= .089/%

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Problem
Strike price = 25; Risk free rate of interest = 6%
Time to maturity = 0.5 years; Stock volatility = 30%

Establish the relationship between option price, delta, gamma and underlying
price.
Stock price

Call price

Intrinsic
value

Delta

Gamma

10

.00001

15

.01626

0.0153

.0121

20

.45875

0.2106

.0680

25

2.47066

.5977

.0730

27.5

4.17428

2.5

.757

.0536

30

6.21317

.8658

.0340

32.5

8.46707

7.5

.9311

.0192

35

10.844409

10.0

.9666

.0100

40

15.75

15

.9931

.0023

45

20.7425

20

.9987

.0004
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Problem
Calculate the delta of an at-the-money 6-month European call option on a nondividend-paying stock when the risk-free interest rate is 10% per annum and the
stock price volatility is 25% per annum.

In this case S0 = K, r = 0.1, = 0.25, and T = 0.5. Also,

2
ln(
S
/
K
)

(
0
.
1

0
.
25
/ 2)0.5
0
d
0.3712
1
0.25 0.5

The delta of the option is N(d1) or 0.6450.

We can also calculate using Deriva Gem.

Ref : John C Hull, Options, Futures and Other Derivatives,

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Problem
The Black-Scholes price of an out-of-the-money call option with an exercise
price of $40 is $4. A trader who has written the option plans to use a stop-loss
strategy. The traders plan is to buy at $40.10 and to sell at $39.90. Estimate
the expected number of times the stock will be bought or sold.
Solution
The strategy costs the trader $0.20 each time the stock is bought and sold.
The total expected cost of the strategy, in present value terms, must be $4.
So the expected number of times the stock will be bought and sold is
approximately 20 each.

Ref : John C Hull, Options, Futures and Other Derivatives,

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Problem
What is the delta of a short position in 1,000 European call options on silver
futures? The options mature in 8 months, and the futures contract underlying the
option matures in 9 months. The current 9-month futures price is $8 per ounce,
the exercise price of the option is $8, the risk-free interest rate is 12% per
annum, and the volatility of silver is 18% per annum.
The delta of a European futures option is usually defined as the rate of change
of the option price with respect to the futures price (not the spot price).
It is

e-rT N(d1)

In this case F0 = 8, K = 8, r = 0.12, = 0.18, T = 0.6667

ln(8 / 8) (0.182 / 2) 0.6667

d1
0.0735
0.18 0.6667
N(d1) = 0.5293 and the delta is e-0.12x0.6667 x 0.5293 = 0.4886
The delta of a short position in 1000 futures options is therefore -488.6.

Ref : John C Hull, Options, Futures and Other Derivatives,

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