EF4523 Quantitative Methods in Finance: Gamma-Neutral Hedging Introduction - Logic Gamma is a measure of sensitivity of the hedge ratio to the

movement in the underlying asset. For hedging, we need to minimize the need to rebalance so as to reduce exposure to hedging error and thus we can achieve this using a gamma-neutral strategy, that is to set the gamma of a portfolio to zero. This hedging strategy also improves the weakness of the delta hedging as delta hedging requires us to rebalance the hedging portfolio continuously and its transaction costs can be large. This is not realistic for us to do so. The purpose of the gamma-natural hedging is to keep the delta value of a position completely stagnant no matter how the underlying asset moves. Mechanism Set to be the gamma of a delta-neutral portfolio and ' to be a gamma of the options used to hedge and b be the number of options used to hedge

b' 0 b

'

However, this addition of option definitely changes the delta of the entire portfolio. To rectify this, we trade a certain number of the underlying asset to make the entire portfolio delta-natural.