The Greek Letters

B. B. Chakrabarti
Professor of Finance

Indian Institute of Management,

Calcutta

Option Portfolio Value and

Greeks
Option portfolio value, fn (s, t, r, )
Using Taylor series expansion,

1 2

* s
* t
* r
* * 2 * s 2
s
t
r

2 s
1
* s * t * r * * * s 2
2

B. B. Chakrabarti: [email protected]

Delta
Delta () is the rate of change of the option price with respect to
the underlying.
If c is the price of the call option and S is the stock price,

then,
Option
price

c
S

Slope =

B
A

Stock price

B. B. Chakrabarti: [email protected]

Delta
Delta denotes the movement of the option position
relative to the movement of the underlying position.
So, Delta is the speed of change of option value when
underlying asset value changes.
Delta is another way of expressing the probability of
an option expiring in the money.
ATM call options have a Delta of 0.5 or 50% meaning
a 50% chance of expiring ITM.
Deep ITM call will have a Delta of 1 meaning a 100%
chance of expiring ITM.
Deep OTM call will have a Delta close to zero meaning
a near zero chance of expiring ITM.
B. B. Chakrabarti: [email protected]

Delta
Delta Range
Long call
0 to 1.00
Short call
0 to -1.00
Long put
0 to -1.00
Short put
0 to 1.00
Delta Range Rules of Thumb (Long Call)
Deep-in-the-money
0.75 to 1.00
Slightly-in-the-money
0.55 to 0.75
At-the-money
0.45 to 0.55
Slightly-out-of-the-money
0.25 to 0.45
Deep-out-of-the-money
0 to 0.25
Delta of long stock is 1 and -1 for short stock.
B. B. Chakrabarti: [email protected]

Delta of European Options

The delta for a European call on a nondividend paying stock = N (d 1)
The delta for a European put on a nondividend paying stock =N (d 1) 1
The delta of a European call on a asst
paying dividends at rate q is N (d 1)e qT
The delta of a European put on this asset
is e qT [N (d 1) 1]
B. B. Chakrabarti: [email protected]

Position Delta
Position Delta or Delta of a portfolio of options or
other derivatives dependent on a single asset whose
price is S and the value of the portfolio is is

The delta of the portfolio can be calculated from the

deltas of the individual options in the portfolio.
If a portfolio consists of a quantity wi of option i (1 < i <
n), the Position Delta is n
wi i
i 1

where i is the delta of ith option.

B. B. Chakrabarti: [email protected]

Delta of a Portfolio Example

Suppose a financial institution in the United States has
the following three positions in options on the Australian
dollar:
1. A long position in 100,000 call options with strike price 0.55
and an expiration date in three months.
The delta of each option is 0.533.

2. A short position in 200,000 call options with strike price 0.56

and an expiration date in five months.
The delta of each option is 0.468.

3. A short position in 50,000 put options with strike price 0.56

and an expiration date in two months.
The delta of each option is 0.508.

The delta of the whole portfolio is

= 100,000*0.533 200,000*0.468 50,000*( 0.508)
= 14,900
This means that the portfolio can be made delta neutral
with a long position of 14,900 Australian dollars.
B. B. Chakrabarti: [email protected]

Delta Hedging Schemes

A position with a delta of zero is referred to as
being delta neutral.
Because delta changes, the investor's position
remains delta hedged (or delta neutral) only for a
relatively short period of time. The hedge has to
be adjusted periodically. This is known as
rebalancing.
The delta-hedging scheme with intermediate
adjustment is called dynamic-hedging
scheme.
B. B. Chakrabarti: [email protected]

Making Position Delta Neutral

Example
A U.S. bank has sold six-month put options on
1 million with a strike price of 1.6000 and
wishes to make its portfolio delta neutral.
Suppose that the current exchange rate is
1.6200, the risk-free interest rate in the United
Kingdom is 13% per annum, the risk-free
interest rate in the United States is 10% per
annum, and the volatility of sterling is 15%.
In this case, So = 1.6200, K = 1.6000, r = 0.10, rf
= 0.13, = 0.15, and T = 0.5.
The delta of a put option on a currency is
e rfT [N (d 1) 1]
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10

Making Position Delta Neutral

Example contd.
It can be shown that
d1 = 0.0287 and N(d1) = 0.51 15
Hence, the delta of the put option is 0.458.
This is the delta of a long position in one put option.
It means that when the exchange rate increases by S, the price
of the put goes down by 45.8% of S.
The delta of the bank's total short option position is +458,000.

To make the position delta neutral, we must therefore

add a short sterling position of 458,000 to the
option position.
This short sterling position has a delta of 458,000 and
neutralizes the delta of the option position.
B. B. Chakrabarti: [email protected]

11

Using Futures for Delta Hedging

The delta of a futures contract 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.

B. B. Chakrabarti: [email protected]

12

Theta
Theta () of a derivative (or portfolio of derivatives) is
the rate of change of the value with respect to the passage
of time.

f
of a call or put
t

Theta stands for the option positions sensitivity to time

decay.
Long (Short) options have negative (positive) Theta
meaning that time decay is eroding the time value portion
of the option value as days pass.
Time decay thus hurts an option buyer and helps option
writers position.
B. B. Chakrabarti: [email protected]

13

Theta for NDPS European Calls and Puts

For a European call on non - dividend paying stock :
S 0 N ' (d1 )
(call)
rKe rT N (d 2 )
2 T
For a European put on non - dividend paying stock :
S 0 N ' (d1 )
(put)
rKe rT N ( d 2 )
2 T
ln( S0 / K ) (r 2 / 2)T
where d1
T
ln( S0 / K ) (r 2 / 2)T
d2
d1 T
T
B. B. Chakrabarti: [email protected]

14

Theta for DPS European Calls and Puts

For a European call on asset paying dividend at rate q :
S 0 N ' (d1 )e qT
(call)
qS 0 N (d1 )e qT rKe rT N (d 2 )
2 T
For a European put on asset paying dividend at rate q :
S 0 N ' (d1 )e qT
(put)
qS0 N (d1 )e qT rKe rT N (d 2 )
2 T
ln( S 0 / K ) (r q 2 / 2)T
where d1
T
ln( S 0 / K ) (r q 2 / 2)T
d2
d1 T
T
B. B. Chakrabarti: [email protected]

15

Theta Example
Consider a four-month put option on a stock index. The
current value of the index is 305, the strike price is 300, the
dividend yield is 3% per annum, the risk-free interest rate is
8% per annum, and the volatility of the index is 25% per
annum.
In this case So = 305, K = 300, q = 0.03, r = 0.08, = 0.25, and T =
0.3333.

The option's theta is

S 0 N ' (d1 )e qT

qS 0 N (d1 )e qT rKe rT N (d 2 )
2 T

= 18.15
= 18.15/365 = -0.0497 per calendar day
= 18.15/252 = -0.0720 per trading day
B. B. Chakrabarti: [email protected]

16

Gamma
Gamma () is the rate of change of delta () with
respect to the price of the underlying asset.

S S 2
If gamma is small, delta changes slowly, and
adjustments to keep a portfolio delta neutral need to be
made only relatively infrequently.
If gamma is large in absolute terms, delta is highly
sensitive to the price of the underlying asset.

B. B. Chakrabarti: [email protected]

17

Gamma
Gamma can be viewed in two ways.
a) as the acceleration of the option position relative to
the underlying stock price.
b) as the odds of a change in Delta.
Gamma is effectively an early warning that Delta could be
about to change.
Both calls and puts have positive Gammas.
Deep OTM and deep ITM options have near zero Gamma
because the odds of a change of delta are very low.
Logically Gamma tends to peak around the strike price.

B. B. Chakrabarti: [email protected]

18

Gamma as Curvature in Option Price

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

Slightly Positive Gamma

Slightly Negative Gamma

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Interpretation of Gamma contd.

S
S

Large Positive Gamma

Large Negative Gamma

B. B. Chakrabarti: [email protected]

21

Making a Portfolio Gamma Neutral

Making a delta-neutral portfolio gamma
neutral can be regarded as a first correction for the
fact that the position in the underlying asset cannot
be changed continuously when delta hedging is
used. An option on the underlying asset is used for
this purpose. The underlying asset cannot be used
because its gamma is zero.
Delta neutrality provides protection against
relatively small stock price moves between
rebalancing.
Gamma neutrality provides protection against
larger movements in the stock price between hedge
rebalancing.
B. B. Chakrabarti: [email protected]

22

Making a Portfolio Gamma Neutral

Example
Suppose that a portfolio is delta neutral and has a
gamma of -3,000.
The delta and gamma of a particular traded call option
are 0.62 and 1.50, respectively.
The portfolio can be made gamma neutral by including
in the portfolio a long position of (3,000/1.5) =
2,000 in the call option.
However, the delta of the portfolio will then change from
zero to 2,000*0.62 = 1,240.
A quantity 1,240 of the underlying asset must
therefore be sold from the portfolio to keep it delta
neutral.
B. B. Chakrabarti: [email protected]

23

Calculation of Gamma
For a European call or put on non - dividend paying stock :
N ' (d1 )

S0 T
ln(S 0 / K ) (r 2 / 2)T
where d1
T
For a European call or put on asset paying dividend at rate q :
N ' (d1 )e qT

S 0 T
ln(S 0 / K ) (r q 2 / 2)T
where d1
T
B. B. Chakrabarti: [email protected]

24

Gamma Example
Consider a four-month put option on a stock index. The
current value of the index is 305, the strike price is 300,
the dividend yield is 3% per annum, the risk-free interest
rate is 8% per annum, and volatility of the index is 25%
per annum.
In this case, So = 305, K = 300, q = 0.03, r = 0.08, =
0.25, and T = 4/12.
The gamma of the index option is given by
N ' (d1 )e qT

S T =0.00857
0

Thus, an increase of 1 in the index (from 305 to

306) increases the delta of the option by
approximately 0.00857.
B. B. Chakrabarti: [email protected]

25

Relationship Between Delta,

Gamma, and Theta
Portfolio value satisfies the differential equation :

1 2 2 2
rS
S
r
2
t
S 2
S

;
S
S 2
1
Hence, rS 2 S 2 r
2
For neutral portfolio,

But,
;
t

1
2 S 2 r
2
B. B. Chakrabarti: [email protected]

26

Relationship Between Delta,

Gamma, and Theta With Dividend
For a portfolio of derivatives on a stock
paying a continuous dividend yield at
rate q

1 2 2
(r q ) S S r
2

B. B. Chakrabarti: [email protected]

27

Vega
Vega () is the rate of change of the value of a
derivatives portfolio with respect to volatility.

Options tend to increase in value when the underlying

assets volatility increases.
Volatility helps the option buyers and hurts the writers.
Vega is positive for long options and negative for short
options.
Vega tends to be greatest for options that are close to atthe-money.
B. B. Chakrabarti: [email protected]

28

Calculation of Vega
For a European call or put on non - dividend paying stock :

S0 T N ' (d1 )
ln(S 0 / K ) (r 2 / 2)T
where d1
T
For a European call or put on asset paying dividend at rate q :

S0 T N ' (d1 )e qT
ln(S 0 / K ) (r q 2 / 2)T
where d1
T

B. B. Chakrabarti: [email protected]

29

Managing Delta, Gamma, & Vega

Delta 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.

B. B. Chakrabarti: [email protected]

30

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

rho
r

For currency options there are 2 rhos

corresponding to two interest rates.
For European options on no - dividend paying stocks,
rho(call) KTe N(d ) and
rho(put) - KTe N(-d )
- rt

- rt

B. B. Chakrabarti: [email protected]

31

Rho
Rho stands for the option positions
sensitivity to interest rates.
A positive Rho means that higher interest
rates are helping the position and a negative
Rho means that higher interest rates are
hurting the position.
Rho is the least important of all the Greeks
as far as stock options are concerned.

B. B. Chakrabarti: [email protected]

32

Positive or Negative Sign of Greeks

A plus or minus sign for a Greek is based
on the assumption that the underlying
stock price rises, time is moving forward,
volatility and interest arte are increasing.
A Greek can be positive or negative
number , depending on long or short
option and whether it is a call or put.

B. B. Chakrabarti: [email protected]

33

Positive or Negative Sign of Greeks

Option
Long call
Short call
Long put
Short put

Delta Gamma Vega Theta

+
+
+
+
+

+
-

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+
-

34

Hedging Principle
n

For neutrality, p wi i 0
i 1

For neutrality, p wi i 0
i 1
n

For neutrality, p wi i 0
i 1

For self - financing at date 0, wi Value i 0

i 1

B. B. Chakrabarti: [email protected]

35

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.

B. B. Chakrabarti: [email protected]

36

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

B. B. Chakrabarti: [email protected]

37

Portfolio Insurance
Portfolio insurance is done by buying a
put option on the portfolio.
One approach is to buy put options on a
market index or to create the options
synthetically.
This involves initially selling enough of
the portfolio (or of index futures) and
the proceeds invested in a riskless asset
to match the of the put option.
B. B. Chakrabarti: [email protected]

38

Portfolio Insurance contd.

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.

B. B. Chakrabarti: [email protected]

39

Portfolio Insurance Example 17.9

A portfolio is worth $90 million. For protection against
market decline, a 6-month European put option on the
portfolio at strike price $87 million is required.
r=9% pa, q=3% pa, T=0.5 yr, =25% pa, S&P 500 index
stands at 900, K=870. The value of one index contract is
$100,000. Assume that the portfolio mimics S&P 500
index closely.
Delta of the required put option
= e qT [N (d 1) 1] = -0.3215
So, 32.15% of the portfolio should be sold initially and invested
in a riskless asset to match the delta of the required option. If
after 1 day, the value of the portfolio reduces to $88 million and
the delta changes to -0.3679, a further 4.64% of the original
portfolio should be sold.
B. B. Chakrabarti: [email protected]

40

Problem No. 17.14 (Hull 7th Ed.)

A financial institution has just sold 1,000 sevenmonth European call options on the Japanese
yen. Suppose that the spot exchange rate is 0.80
cents per yen, the exercise price is 0.81 cents per
yen, the risk-free interest rate in the United
States is 8% per annum, the risk-free interest
rate in Japan is 5% per annum, and the volatility
of the yen is 15% per annum. Calculate the delta,
gamma, vega, theta, and rho of the financial
institution's position. Interpret each number.
B. B. Chakrabarti: [email protected]

41

Problem No. 17.14 (Ans.)

In this case,
S0 0.80, K 0.81, r 0.08, rf 0.05, 0.15 and T 0.5833
ln (0.80 / 0.81) (0.08 0.05 0.152 / 2) 0.5833
d1
0.1016
0.15 0.5833
d 2 d1 0.15 0.5833 0.0130
N (d1 ) 0.5405;

N (d 2 ) 0.4998

The delta of one call option is e rf N (d1 ) e 0.05*0.5833 * 0.5405

0.5250.
1 d12 / 2
1 0.00516
N ' (d1 )
e

e
0.3969
2
2
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42

Problem No. 17.14 (Ans. contd.)

Hence, gamma of one call option is
N ' (d1 )e rf T
0.3969 * 0.9713

4.206
S T
0.80 * 0.15 * 0.5833
The vega of one call option is
S0 T N ' (d1 )e rf T 0.80 0.5833 * 0.3969 * 0.9713 0.2355
The theta of one call option is
S0 T N ' (d1 )e rf T

rf S0 N (d1 )e rf T rKe rT N (d 2 )
2 T
0.8 * 0.3969 * 0.15 * 0.9713

2 * 0.5833
0.05 * 0.8 * 0.5405 * 0.9713 0.08 * 0.81* 0.9544 * 0.4948 0.3933
B. B. Chakrabarti: [email protected]

43

Problem No. 17.14 (Ans. contd.)

The rho of one call option is
KTe N (d ) 0.81 * 0.5833 * 0.9544 * 0.4948
rT

0.2231
Interpretation of Delta : When the spot price increases
by a small amount (measured in cents), the value of an
option to buy one yen increases by 0.525 times that
amount.
Interpretation of Gamma : When the spot price increases
by a small amount (measured in cents), the delta
increases by 4.206 times that amount.
B. B. Chakrabarti: [email protected]

44

Problem No. 17.14 (Ans. contd.)

Interpretation of Vega : When the volatility (measured in
decimal form), increases by a small amount, the option' s
value increases by 0.2355 times that amount.
Interpretation of Theta : When a small amount of time
(measured in years) passes, the option' s value decreases
by 0.3933 times that amount.
Interpretation of Rho : When the interest rate (measured
in decimal form), increases by a small amount, the
option' s value increases by 0.2231 times that amount.

B. B. Chakrabarti: [email protected]

45

Problem No. 17.22 (Hull 7th Ed.)

A bank's position in options on the dollar-euro
exchange rate has a delta of 30,000 and a
gamma of -80,000. Explain how these numbers
can be interpreted. The exchange rate (dollars
per euro) is 0.90. What position would you take
to make the position delta neutral? After a short
period of time, the exchange rate moves to 0.93.
Estimate the new delta. What additional trade is
necessary to keep the position delta neutral?
Assuming the bank did set up a delta-neutral
position originally, has it gained or lost money
from the exchange rate movement?
B. B. Chakrabarti: [email protected]

46

Problem No. 17.22 (Ans.)

The delta indicates that when the value of the euro
exchange rate increases by $0.01, the value of the banks
position increases by 0.01*30,000= $300.
The gamma indicates that when the value of the euro
exchange rate increases by $0.01, the delta of the
portfolio decreases by 0.01*80,000= $800.
For delta neutrality 30,000 euros should be shorted.
When the exchange rate moves up to 0.93, we expect the
delta of the portfolio to decrease by (0.93
0.90)*80,000 = 2,400 so that it becomes 27,600.
To maintain delta neutrality, it is therefore necessary for
the bank to unwind its short position 2,400 euros so that
a net 27,600 has been shorted.
B. B. Chakrabarti: [email protected]

47

Problem No. 17.22 (Ans. contd.)

As shown in the figure below, when a portfolio is delta
neutral and has a negative gamma, a loss is experienced
when there is a large movement in the underlying asset
price. We can conclude that the bank is likely to have lost
money.

Slightly Negative Gamma

Large Negative Gamma

B. B. Chakrabarti: [email protected]

48

Problem No. 17.25 (Hull 6th Ed.)

A financial institution has the following portfolio of over-thecounter options on sterling:
Type Position Delta of option Gamma of option Vega of option
Call

-1,000

0.5

2.2

1.8

Call

-500

0.8

0.6

0.2

Put

-2,000

-0.4

1.3

0.7

Call

-500

0.7

1.8

1.4

A traded option is available with a delta of 0.6, a gamma of 1.5, and a

vega of 0.8.
a. What position in the traded option and in sterling would make the
portfolio both gamma neutral and delta neutral?
b. What position in the traded option and in sterling would make the
portfolio both vega neutral and delta neutral?
B. B. Chakrabarti: [email protected]

49

Problem No. 17.25 (Ans.)

The delta of the portfolio
= 1,000*0.50 500*0.8 2,000*(0.40) 500*0.70
= 450

The gamma of the portfolio

= 1,000*2.2 500*0.6 2,000*(1.3) 500*1.8
= 6,000

The vega of the portfolio

= 1,000*1.8 500*0.2 2,000*0.7 500*1.4
= 4,000
B. B. Chakrabarti: [email protected]

50

Problem No. 17.25 (Ans. contd.)

Part a:
A long position in 4,000 traded option will give a
gamma-neutral portfolio since the long position
has a gamma of 4,000*1.5 = 6,000.
The delta value of the whole portfolio (including
traded options) is then
= 4,000*0.6 450 = 1,950
Hence in addition to the 4,000 traded options, a
short position in 1,950 is necessary so that the
portfolio is both gamma and delta neutral.
B. B. Chakrabarti: [email protected]

51

Problem No. 17.25 (Ans. contd.)

Part b:
A long position in 5,000 traded option will give a veganeutral portfolio since the long position has a vega of
5,000*0.8 = 4,000.
The delta value of the whole portfolio (including traded
options) is then
= 5,000*0.6 450 = 2,550
Hence in addition to the 5,000 traded options, a short
position in 2,550 is necessary so that the portfolio is
both vega and delta neutral.
B. B. Chakrabarti: [email protected]

52