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A
dynamic hedging strategy typically involves two 1. A SIMPLE EXAMPLE
positions: To start off, consider the following example, which we
have adapted from Hull (1997): A financial institution has
Í A static position in a security or a commitment by a sold a European call option for $300,000. The call is writ-
firm. For example: ten on 100,000 shares of a non-dividend paying stock with
the following parameters:
– A financial institution has written a call on a stock or
a portfolio; this call expires some time in the future Current stock price = $49
and is held by a counterparty which has the choice Strike price = X = $50
of either exercising it or not. Stock volatility = 20%
Risk-free interest rate r = 5%.
– A U.S. firm has committed itself to sell 1000 widgets Option time to maturity T = 20 weeks
at some defined time in the future; the receipts will Stock expected return = 13%
be in German marks.
The Black-Scholes price of this option is slightly over
Í An offsetting position in a financial contract. Typically, $240,000 and can be calculated using the Mathematica
this counter-balancing position is adjusted when market program defined in our previous article:
conditions change; hence the name dynamic hedging
strategy: In[1]:= Clear[snormal, d1, d2, bsCall];
snormal[x_] :=
1/2*Erf[x/Sqrt[2.]] + 0.5;
To hedge its written call, the issuing firm decides to buy
d1[s_, x_, sigma_, T_, r_] :=
shares of the underlying stock or portfolio. The number (Log[s/x] + (r + sigmaˆ2/2)*T)/
of shares purchased at time t will depend on the price (sigma*Sqrt[T]);
of the underlying stock at t and on the amount of time d2[s_, x_, sigma_, T_, r_] :=
remaining until the expiration of the call. Another way of d1[s, x, sigma, T, r] - sigma*Sqrt[T];
bsCall[s_, x_, sigma_, T_, r_] :=
viewing this is that the amount of stock held against the
s*snormal[d1[s, x, sigma, T, r]] -
call position depends on the probability that the option x*Exp[-(r*T)]*
will be exercised. snormal[d2[s, x, sigma, T, r]];
To hedge its anticipated receipt of German marks, the bsPut[s_, x_, sigma_, T_, r_] :=
bsCall[s, x, sigma, T, r] +
firm might enter into a forward contract. This would be
x*Exp[-(r*T)] - s;
a static hedge position. On the other hand, it might buy bsCall[49, 50, 0.2, 20/52, 0.05]*100000.
a put option on Deutschmarks (DM), which would give
Out[1]= 240053.
it the right to sell DM for a given dollar price; this is
still a static hedge position, though somewhat more so- It follows that the financial institution has earned ap-
phisticated. A third possibility would be to dynamically proximately $60,000 from writing the call. However, un-
simulate a put on the DM position, replicating it by hold- less the financial institution hedges its obligation in order
ing amounts of dollars and DM (these amounts changing to offset the effects of price changes in the future, it could
with market conditions). stand to lose much money at the call’s expiration. For ex-
In this article we consider some simple dynamic hedg- ample, if the price of the stock at the option’s expiration
ing strategies and show how to simulate them in Mathe- date is $60, and if the call is not hedged, then the finan-
matica. Our discussion will lead us naturally to the con- cial institution will lose $1,000,000 (=100,000*(60-50)) at
sideration of Value-at-Risk (VaR), a measure of possible the option’s expiration.
future losses which has become increasingly popular. As we shall show, however, this possible future loss can
PROGRAM 1:
Net loan outstanding = Lt = Lt-1*e5%/ 52+(Nt-Nt-1)St In our program this works out as follows: {path,
(i.e., if new shares are bought, they are purchased with price, hedge, stockPostion, priceOfStocks,
borrowed funds, and if shares are sold, the proceeds pay numStockBought, paidForStock, debt} are the lo-
down the loan). cal variables of simulation[nn_]. path is itself a mod-
ule, which creates numPer normally-distributed random
Terminal profitability of the position at t = 20: -100, 000* variables:
Max(S20 - X , 0) - Lt
path:=Module[{}, If[nn!=0,
Program 1 simulates this position. SeedRandom[nn],SeedRandom[]];
Table[Random[NormalDistribution[0,1]], {numPer}]];
gives the list of deltas for the random prices generated. 5. CONCLUSION
To calculate the debt at each point in time, we start off We have shown several simple examples of how to model
with the initial amount of debt initially taken on: dynamic and static hedging strategies. A deeper expla-
nation of related issues can be found in the references
debt = {paidForStock[[1]] - receivedForCalls}
below. In a real world one can not completely hedge
At each time period i, we take the debt[[i-1]], many types of risks. However one can estimate the real-
multiply by one-plus the interest Exp[r*length], and istic losses under normal scenarios using the models we
add the cost of the stock bought at i: have described. This is useful for risk management. After
running a long sequence of Mone Carlo simulations one
Do[AppendTo[debt,debt[[i-1]]* can estimate for example a lower quantile of the value
Exp[r*length] (+) paidForStock[[i]]
],{i,2,numPer+1}]
distribution of a portfolio. This is one of the most popular
risk measuring units,
Note that debt can be either positive or negative (neg- Value-at-Risk (VaR). A strict definition and ways to cal-
ative debt means money invested at the risk-free interest culate it will be discussed later in this series.
rate). The effectiveness of the hedge can be measured by
the amount of debt at the end of the hedging plus the
REFERENCES
cost of honoring the calls written: , . Financial Modeling. MIT Press, Cambridge, Mas-
sachusetts (1997).
debt[[numPer+1]]=
debt[[numPer+1]]+numOptions* , , , Forever Hedged, RISK,
Max[price[[numPer+1]]-strike, 0] 1994, vol. 7, no. 9, p. 141–145.
, , , Static Options Replica-
tion, The Journal of Derivatives, 1995, vol. 2, no. 4, p. 78–95.
Running the hedge simulation
The output of simulation[nn] is a vector of all the re- , , , Optimal Repli-
cation of Options with Transactions Costs and Trading Restrictions, J. of
sults generated, but what really interests us is the first Financial and Quantitative Analysis, vol. 28, no.1, March 1993, p. 117–
element of this vector, Last[debt], which gives the 138.
amount of debt left at the end of 20 weeks. To gener- , ., Options, Futures, and Other Derivatives, third edition, Prentice
ate only this amount, we run simulation[nn][[1]]. Hall, Englewood Cliffs, New Jersey, 1997.
Running this 50 times generates a table of random out- ., Option Pricing and Replicatiion with Transactions
comes: Costs, The Journal of Finance, vol. 40, no.5, December 1985.