TOPIC 9

FINANCE 362: OPTION RISKS

& HEDGING OPTIONS.
1. Greeks
• Chapter 17

2. Greeks of Portfolio
• Chapter 17

3. Delta Hedging
• Chapter 17

2
 PART I:
Greeks I

Key concepts:
• Delta
• Theta
• Vega
• Rho
• Gamma

3
 THE “GREEKS”

Price of option on non-dividend asset depends on:

• price of underlying asset (S)
• exercise price (X)
• time to expiration (T)
• volatility (s)
• risk-free rate (r)

C CS, K, T, σ, r  P PS, K, T, σ, r 
How do C and P respond to changes in S, T, s and r?

4
Definitions

C P
c  p 
Delta: S S
C P
Theta: c  p 
t t
C P
c  p 
Vega:  

C P
c  p 
Rho: r r

2C 2 P
Gamma: c  2 p  2
S S

Defined on a long position. What about a short position?

-1 × Long position Greek

5
Example 1
A non-dividend stock is selling for $45. Call and put options on
the stock with 3 months to expiry have an exercise price of $50.
The risk-free interest rate is 6% p.a. (c.c.) and volatility is 50%
p.a.
What is the delta, theta, vega, rho and gamma of the call and put
options under the BSOPM?

Answer:
Shown in the next slides or:

Delta = 0.4066, -0.5934

Theta = -9.6548, -6.6999 (per year so “per day” × 365)
Vega = 8.7287, 8.7287 (per 1 so “per %” × 100)
Rho = 3.8582, -8.4556 (per 1 so “per %” × 100)
Gamma = 0.0345, 0.0345

6
 Underlying Data Graph Results
Underlying Type: Time Dividend Vertical Axis:

Horizontal Axis:
Stock Price: 45.00
Volatility (% per year): 50.00%
Risk-Free Rate (% per year): 6.00% Minimum X value 1
Maximum X value 100

Draw Graph
Calculate

Option Data 60
Option Type:
Imply Volatility 50

Time to Exercise: 0.2500 Put

40
Exercise Price: 50.00

Option Price
Call
30

20
Price: 2.8614166
Delta (per $): 0.40654489 10
Gamma (per $ per $): 0.03448403
Vega (per %): 0.08728769
0
Theta (per day): -0.0264514
1.00 21.00 41.00 61.00 81.00
Rho (per %): 0.03858276
Asset Price

7
 Underlying Data Graph Results
Underlying Type: Time Dividend Vertical Axis:

Horizontal Axis:
Stock Price: 45.00
Volatility (% per year): 50.00%
Risk-Free Rate (% per year): 6.00% Minimum X value 1
Maximum X value 100

Draw Graph
Calculate

Option Data 60
Option Type:
Imply Volatility 50

Time to Exercise: 0.2500 Put

40
Exercise Price: 50.00

Option Price
Call
30

20
Price: 7.11701358
Delta (per $): -0.5934551 10
Gamma (per $ per $): 0.03448403
Vega (per %): 0.08728769
0
Theta (per day): -0.0183546
1.00 21.00 41.00 61.00 81.00
Rho (per %): -0.0845562
Asset Price

8
 DELTA

Delta is the change in the option price with respect to a change

in the price of the underlying asset.
C P
c  p 
S S

dC Δ c dS dP Δ p dS

and

Under the BSOPM with no dividend:

and

Delta changes with changes in other variables – S, t, σ, r

9
Graphical depiction of call option delta

Option
price

C
Slope = D

K Stock price

10
Graphical depiction of put option delta
$

11
Delta vs stock price
1
Delta

0 S
K

-1

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Problem 1:
Consider the call option in Example 1. What would be the call
price if the share price rises $1.00?

1
→

BSOPM Call price is 3.285 → 3.268 is an approximation

13
 THETA

Theta is the change in the option price with respect to a change

in the time to expiration.

C P
c  p 
t t

dC  c dt dP  p dt

Thetas are usually negative.

Under the BSOPM with no dividend:

,
Where is the normal density function

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Call price v time (theta effect)

t
T
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Theta for call option: S=K=50, σ=25%, r=5%,
T=365 (days)

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Problem 2:
Consider the call option in Example 1. What would be the call
price if one calendar day passes?

(t in years)
→

BSOPM Price = 2.8349

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 VEGA

Vega is the change in the option price with respect to a 1% (or

0.01) change in the volatility of the underlying asset price.
C P
vc  p 
 

dC vc d dP v p d

Vegas on both call options and put options are positive.

Under the BSOPM with no dividend:

Where is the normal density function

18
Vega for call option: S=K=50, σ=25%, r=5%,
T=1 year

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Problem 3:
Consider the call option in Example 1. What would be the call
price if volatility rises to 60% p.a.?

(from 0.5 to 0.6)

→

BSOPM Price = 3.7424

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 RHO

Rho is the change in the option price with respect to a 1% (or

0.01) change in the risk-free interest rate.

C P
c  p 
r r

dC c dr dP  p dr

Under the BSOPM with no dividend:

,

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Problem 4:
Consider the call option in Example 1. What would be the call
price if the risk-free rate rises to 9% p.a.?

3.858276

(from 0.06 to 0.09)

→

BSOPM Price = 2.9787

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Summary of Problems 2 - 4

How much will price of call option change if:

Stock price rises by $1 dC=$0.4066

i.e. dS = $1

One day passes dC=-$0.0265

i.e. dt = 0.00274

Volatility rises from 50%

to 60% p.a. dC=$0.8729
i.e. ds = 0.10
Risk-free rate rises from
6% to 9% p.a. dC=$0.1157
i.e. dr = 0.03

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 GAMMA

Gamma is the rate of change in the option delta with respect to a

change in the price of the underlying asset or the second order
derivative of the option price wrt. the underlying asset price

 C   P 
  2   2
 S   C  S   P
c   2 p   2
S S S S

dΔ c Γ c dS dΔ p  p dS

Under the BSOPM with no dividend:

Where is the normal density function

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Gamma for call option: S=K=50, σ=25%, r=5%,
T=1 year

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Problem 5:
Consider the call option in Example 1. What would be the value of
delta if the share price rises $1.00?

BSOPM delta = 0.440964

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BSOPM Greeks with continuous yield at rate q

Greek Letter Call Option Put Option

Delta e  qT N (d1 ) e  qT  N (d1 )  1

Gamma N (d1 )e  qT N (d1 )e  qT

S 0 T S 0 T

Theta  
 S 0 N (d1 )e  qT 2 T  S 0 N (d1 )e  qT 2 T 
 qS 0 N (d1 )e  qT  rKe  rT N (d 2 )  qS 0 N ( d1 )e  qT  rKe  rT N ( d 2 )

Vega S 0 T N (d1 )e  qT S 0 T N (d1 )e  qT

Rho KTe  rT N (d 2 )  KTe  rT N ( d 2 )

27
 PART II:
MANAGING RISK OF OPTION
PORTFOLIOS

Key concepts:
• Measuring portfolio risks
• Hedging portfolio risks

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 MEASURING PORTFOLIO RISKS

Consider a portfolio comprising:

• positions in N different options written on a stock
• ns units of the underlying stock

Portfolio value:
N
V  n i Oi  n sS
i 1

Portfolio delta:

V N O i S N O i
 n i  ns  n i  ns
S i 1 S S i 1 S
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Portfolio gamma:
2 V N
2Oi  2S N
2Oi
2
 n i 2
 ns 2
 n i
S i 1 S S i 1 S2
Portfolio theta:
N N
V Oi S Oi
 n i  ns  n i
t i 1 t t i 1 t
Portfolio vega:
V N
O i S N
O i
 n i  ns  n i
σ i 1 σ σ i 1 σ
Portfolio rho:
N N
V Oi S Oi
 n i  ns  n i
r i 1 r r i 1 r
30
Risk exposures of the options/stock portfolio:

• All options have a delta, gamma, theta, vega and rho

• The underlying stock (or commodity or foreign currency) has

delta of 1 and gamma, theta, vega and rho of 0

• The exposure of combined options/stock portfolio is the sum

of:
– the exposures to the individual options
– the exposure to the underlying stock

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Problem 1:

An options dealer has the following portfolio in options and stock

of ABC:

Type Position Delta Gamma Vega

Call -200 0.30 0.25 1.50
Put 100 -0.25 0.30 1.40
Stock 30 1.0 0.0 0.0

What is the delta, gamma and vega of this portfolio?

Delta = -200×0.3 + 100×(-0.25) + 30×1 = -55

Gamma = -200×0.25 + 100×0.3 + 30×0 = -20
Vega = -200×1.5 + 100×1.4 + 30×0 = -160

32
 HEDGING PORTFOLIO RISKS

Consider portfolio of n call (put) options on an asset.

To make portfolio “delta-neutral”:

• add position in another instrument (option, asset, futures)

To make portfolio “delta-neutral” and “gamma-neutral”:

• add position in another two instruments

Rule:
To make portfolio “neutral” wrt to k exposures:
• add position in another k instruments

33
Problem 2:
Consider the options dealer with the portfolio in options and
stock of ABC in Problem 1.

(a) What new position in the stock must he take to make

his portfolio delta-neutral?

Current delta = -55 → 55 long units of stock

(b) What new position must he take in the stock and a

new call option with a 0.40 delta, 0.35 gamma and 1.60
vega to make his portfolio both delta- and gamma-neutral?

Step 1: Make the portfolio gamma-neutral using the

option (but not stocks)
Current gamma = -20
-20 + 0.35x = 0 → Long 57 new call options
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 Step 2: Make the portfolio delta-neutral
-55 + 57×0.40 + 1×y = 0 → y = 32
Long additional 32 shares

(c) What new position must he take in the stock and a

new call option with a 0.40 delta, 0.35 gamma and 1.60
vega to make his portfolio both delta- and vega-neutral?

Step 1: Vega-neutral
-160 + 1.6x = 0 → x = 100
Long 100 new calls

Step 2: Delta-neutral
-55 + 100×0.40 + y = 0 → y = 15
Long additional 15 shares

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 HEDGING OPTION PORTFOLIOS IN PRACTICE

Some general principles:

• Traders most concerned about portfolio “delta”

• “Delta” changes over time and with S

– Delta exposure adjusted frequently

• Traders pay little attention to theta, rho of portfolio

• “At-the-money” options have high gamma, vega

– Monitor gamma and vega for “at-the-money” options only

• Futures contracts instead of underlying asset are often used

especially for short positions

36
 DELTA OF A FUTURES CONTRACT

What is the delta of a futures contract on a storable commodity?

• F= e(r+u)TS → ∆F = e(r+u)T

• Required position HF = e-(r+u)T × HA

What is the required position of a futures contract on a foreign

currency?

• HF = e-(r-rf)T × HA

What is the required position of a futures contract on a stock

index?

• HF = e-(r-q)T × HA 37
 PART III:
DELTA HEDGING

Key concepts:
• Delta hedging a short call
• Delta hedging a short put
• Limitations of delta hedging

38
The following examples of delta hedging use data on call and
put options on Telecom stock:

Type K T Delta Gamma

Call $50 1.0 0.627 0.030
Put $50 1.0 -0.389 0.035

S = $50, s = 25% and r = 5%

BSOPM values call at $6.17, put at $3.73

39
 DELTA HEDGING A SHORT CALL

Consider a bank which:

• sells a call option on Telecom, and
• holds ns units of Telecom stock

Portfolio value is
V  n sS  C
and portfolio delta is

V C
n s 
S S

40
For this portfolio to be “delta neutral”
V
0
S
C
i.e. n s  0
S

Bank must hold delta units (i.e., 0.627) of Telecom stock for each
call option sold
 Short call delta = -0.627

Bank must adjust stock position as S and delta change

 if S rises, delta rises towards 1 so bank buys more stock
 If S falls, delta falls towards 0 so bank sells some stock
position

41
But dynamic hedging only works for small DS

S=40 S=49 S=51 S=60

DS=-10 DS=-1 DS=+1 DS=+10

Change in value 0.627 x -$10 = 0.627 x -$1 = 0.627 x $1 = 0.627 x $10 =

of stock position -$6.27 -$0.63 $0.63 $6.27

Change in value C*=$1.57 C*=$5.56 C*=$6.81 C*=$13.70

of option position DC = $4.60 DC = $0.61 DC = -$0.64 DC = -$7.53

Change in value DV = -$1.67 DV = -$0.02 DV = -$0.01 DV = -$1.26

of hedge portfolio

Points to note:
• Portfolio value undergoes large changes when DS is large
• Portfolio decreases when changes in S occur – this is due to
“negative gamma” of portfolio

42
DELTA HEDGING A SHORT PUT

Consider a bank which:

• sells a put option on Telecom, and
• holds ns units of Telecom stock

Portfolio value is

V  n sS  P
and portfolio delta is

V P
n s 
S S

43
For this portfolio to be “delta neutral”
V
0
S
P
i.e. n s   0
S

Bank must short sell delta units (i.e., -0.389) of the underlying
asset for each put option sold.

Bank must adjust holding of stock as S and delta change

 if S rises, delta rises towards 0, bank must buy stock
(reduce short position)
 If S falls, delta falls towards -1, bank must sell short more
stock (increase short position)

44
Again, dynamic hedging only works for small DS

S=40 S=49 S=51 S=60

DS=-10 DS=-1 DS=+1 DS=+10

Change in value -0.389 x -$10 = -0.389 x -$1 = -0.389 x $1 = - -0.389 x $10 =

of stock position $3.89 $0.39 $0.39 -$3.89

Change in value P*=$9.13 P*=$4.12 P*=$3.37 P*=$1.26

of option position DP = -$5.40 DP = -$0.39 DP = $0.36 DP = $2.47

Change in value DV = -$1.51 DV = $0.00 DV = -$0.03 DV = -$1.42

of hedge portfolio

Points to note:
• Portfolio value undergoes large changes when DS is large
• Portfolio decreases when changes in S occur – this is due to
“negative gamma” of portfolio

45
 LIMITATIONS OF “DELTA HEDGING”

1. As S changes, so does the option delta

 Need to continually adjust ns which can be costly
 Moreover, rebalancing is a buy-high, sell-low trading
strategy

2. delta hedging only works for very small changes in S

 also need to incorporate gamma to make V immune to
large changes in S

If C=C(S) then the Taylor’s series expansion for dC is

C 1 2C 1  3C
dC  dS  2
dS 2
 3
dS 3
 .....
S 2 S 6 S
Ignoring gamma and other terms means we estimate dC
with errors.
46
C

47