The Greek Letters

Derivatives (Term IV) 2016

Dr. Kulbir Singh (IMT-N)
Example
A bank has sold for $300,000 a European
call option on 100,000 shares of a non-
dividend paying stock
S0 = 49, K = 50, r = 5%, = 20%,
T = 20 weeks, = 13%
Black-Scholes Value of one call option is
$2.40
The value of the 100,000 options is $240,000
How does the bank hedge its risk to lock in a
$60,000 profit?

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Naked & Covered Positions
Naked position
Take no action
Covered position
Buy 100,000 shares today

Both strategies leave the Investor in OTC

market exposed to significant risk

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Stop-Loss Strategy
This involves:
Buying 100,000 shares as soon as price
reaches $50
Selling 100,000 shares as soon as price falls
below $50
This deceptively simple hedging strategy
does not work well

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 Sell

Buy

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Other Advanced Hedging
Techniques
Most traders use more sophisticated
hedging procedures like:
Delta
Gamma
Vega

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Delta
Delta () is defined as the rate of change of
the option price with respect to the underlying
asset.

=

Example: If = 0.6
It means that if stock price is $100 and Option
price is $10, and if stock price increases by
10% ($100 to $110),
Option price increases by 6% (0.6 x 10%)
($10 to $10.60)
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Delta
Delta is the slope of the curve that relates
the option price to the u/lg asset price

Option
price

Slope =
B

A Stock price

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Delta
Let stock price is $100 and Option price is
$10,
An investor has sold options to buy 2000
shares of a stock (if 1 option = 1 shares, then
2000 options)
How to hedge his/her risk?
Buy underlying shares. How many?
x 2000 shares = 0.6 x 2000 = 1200 shares
Gain/loss on stock position would then will be
offset by loss/gain on the option position.
How?
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Delta
Situation #1:
If Stock price goes up by $1, gain on stock
position = 1200 x $1 = $1200.
But loss on option position (why loss?)
Due to rise in price of option. Option price
goes by 0.6 x $1 = $0.60 x 2000 = $1200
loss to the writer.
Situation #2:
If Stock price goes down by $1

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Delta
Here trader:
Loses on Options Position: 1200S, when stock
price increases by S
Gains on long position on 1200 shares: Delta of
Shares x No. of Shares = 1 x 1200 = $1200. (Delta
of share is 1)
Delta of the traders overall position is ZERO.
Delta of stock position offsets the delta of the
option position.
A position of delta of zero is referred to as
delta neutral.

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Delta Hedging
Delta of an option does not remain constant.
Hedge has to be adjusted periodically, known as
Rebalancing.
Dynamic hedging vs. Static Hedging
(hedge-and-forget)

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 Delta Hedging .
According to BSM Model, delta of a European
call on a non-dividend paying stock is
(Call) = N(d 1)
Delta of LONG position in 01 call option = N(d1)
Delta of SHORT position in 01 call option = -N(d1)
Using delta hedging for a SHORT position in a Eur. Call
Option involves maintaining a LONG position of N(d 1)
for each position sold.
Using delta hedging for a LONG position in a Eur. Call
Option involves maintaining a SHORT position of N(d 1)
for each position sold.

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Delta Hedging .
Delta of a European put on the stock is
(Put) = N (d 1) 1
Delta is Negative.
Which means that
LONG position in put option should be hedged with a
LONG position in the u/lg asset, and
SHORT position in put option should be hedged with a
SHORT position in the u/lg asset.

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Derivatives (Term IV) 2016 Dr. Kulbir Singh (IMT-N) 15
Derivatives (Term IV) 2016 Dr. Kulbir Singh (IMT-N) 16
 Delta Hedging Numerical
Consider a call option on a non-dividend
paying stock when stock price is $49, the
strike price is $50, the risk-free interest rate
is 5%, the time to maturity is 20 weeks
(0.3846 years), and volatility is 20%.
European call option is on 100,000 shares.
Amt to be paid at T (if exercised) $5m.
Find Delta for the call option.
Ans: N(d1) = 0.522

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Dynamic Aspects of Delta
Hedging
Lets see how Delta hedging is improvement
over Stop-Loss strategy.

Case I :Option closes in the money (ITM)

Call Option: ST > K
Put Option: ST < K
Case II :Option closes out of the money
(OTM)
Call Option: ST < K
Put Option: ST > K

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Case I

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Case II

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Delta of a Portfolio
Delta of a portfolio of options or other
derivatives dependent on a single asset whose
price is is:

=

Where is the value of the portfolio.
If the portfolio consists of a quantity of option
1 , the delta of the portfolio is given
by:

=
=1
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Delta of a Portfolio: Example
Suppose a financial institution has the following three
positions in options on a stock:
A long position in 100,000 call options with strike price $55 and
an expiration date in 3 months. The delta of each option is
0.533.
A short position in 200,000 call options with strike price $56 and
an expiration date in 5 months. The delta of each option is
0.468.
A short position in 50,000 put options with strike price $56 and
an expiration date in 2 months. The delta of each option is -
0.508.
The delta of the whole portfolio is
100,000 X 0.533 200,000 x X 0.468 50,000 x (-0.508) = -14,900
This means that the portfolio can be made delta neutral
by buying 14,900 shares.
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Theta
Theta () of a derivative (or portfolio of
derivatives) is the rate of change of the value with
respect to the passage of time
Also called Time Decay.
The theta of a call or put is usually negative.
This means that, if time passes with the price of
the underlying asset and its volatility remaining the
same, the value of a long option declines. (see fig.
18.6 page 413)

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Gamma
Gamma () is the rate of change of delta
() with respect to the price of the
underlying asset
Gamma is greatest for options that are
close to the money (see fig. 18.9 page
416)

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Gamma Addresses Delta Hedging
Errors Caused By Curvature

Call
price

C''
C'

C
Stock price
S S'

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Interpretation of Gamma
For a delta neutral portfolio,
t + S 2

S
S

Positive Gamma Negative Gamma

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 Relationship Between Delta,
Gamma, and Theta

For a portfolio of derivatives on a

stock paying a continuous dividend
yield at rate q

1 2 2
+ rS + S = r
2

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Vega
Vega () is the rate of change of the
value of a derivatives portfolio with
respect to volatility
Vega tends to be greatest for options that
are close to the money (See Figure
18.11, page 421)

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 Managing Delta, Gamma, &
Vega

can be changed by taking a position in

the underlying
To adjust & it is necessary to take a
position in an option or other derivative

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Rho
Rho is the rate of change of the value
of a derivative with respect to the
interest rate

For currency options there are 2 rhos

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Hedging in Practice
Traders usually ensure that their portfolios
are delta-neutral at least once a day
Whenever the opportunity arises, they
improve gamma and vega
As portfolio becomes larger hedging
becomes less expensive

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Scenario Analysis
A scenario analysis involves testing the
effect on the value of a portfolio of different
assumptions concerning asset prices and
their volatilities

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Greek Letters for Options on
an Asset that Provides a
Dividend Yield at Rate q
See Table 18.6 on page 423

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Futures Contract Can Be Used
for Hedging

The delta of a futures contract on an asset

paying a yield at rate q is e(r-q)T times the
delta of a spot contract
The position required in futures for delta
hedging is therefore e-(r-q)T times the
position required in the corresponding spot
contract

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Hedging vs Creation of an
Option Synthetically
When we are hedging we take
positions that offset , , , etc.
When we create an option
synthetically we take positions that
match , , &

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Portfolio Insurance

In October of 1987 many portfolio

managers attempted to create a put option
on a portfolio synthetically
This involves initially selling enough of the
portfolio (or of index futures) to match the
of the put option

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Portfolio Insurance

As the value of the portfolio increases, the

of the put becomes less negative and some
of the original portfolio is repurchased
As the value of the portfolio decreases, the
of the put becomes more negative and
more of the portfolio must be sold

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Portfolio Insurance

The strategy did not work well on October

19, 1987...

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