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Uploaded by Jasvinder Josen

Measuring delta in financial pro folios is crucial. I show the practical method used to measure delta by market practiotioners.

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derivatives world

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aintaining a portfolio of fi-

banks. Hand in hand with maintaining the (or gradient) of the price graph of a particular portfolio is managing the risk that the port- nancial instrument. Note that the curve is Say a incur losses from fluctuations in now oil futures. She knows measure folio will trader holds a portfolio of palm represented by a straight line towhat its market value is today, the prices of securities in the portfolio. This itsvalue a week from today. The by but she is uncertain as to its market steepness. The steepness is measured trader wants to identify is market risk. this a trader holds a portfolio of palm oil dividing theconsiders excessive.of the risk and reduce any exposuresinstrument over the price movement In other words, she wants that she price movement of the nancial Say manage the market market value is underlying asset. The more sensitive the - Chart 3: Current Interest rate curve futures. He knows what itsrisk. How does she do it? today, but he is uncertain as to its market nancial instrument to the change in the price value a week from today. The trader wants of the underlying asset, the steeper its price In order to manage market risk, the trader must first be able to measure this risk. In a series to identify this risk and reduce any exposure curve and hence the larger the delta. of two articles, I describe the delta, the most common kind of market risk. After explaining that he considers excessive. In other words, he wants to manage theand how it How How is the delta measured inapplications on how delta is used practice? what delta means market risk. is measured, I show practicala very simple does he do it? Global market practitioners use in portfolio management using simple hypotheticaldelta risk. This method To do this, the trader must rst be able technique to quantify portfolios. to measure the risk. In a series of two arti- is frequently referred to as bumping. First, cles, I describe the delta, the most common the underlying assets price is bumped by What is Delta kind of market risk. After explaining what a small decimal point. Next, all nancial inChart 4: Measuring the Delta delta means and how it is measured, I show struments that are sensitive to that underThe delta is simply the change in lying asset are priced again with when the practical applications of the delta in portfo- a financial products price the newly underlying asset lio managementvalue. changes in using simple hypothetical bumped underlying assets price. The dif- Chart 4: Measuring the Delta portfolios. ference in the value of the nancial instru- Chart 4: Measuring the Delta ments with the bumping is known as the For example, a What is the delta? bonds price will change delta exposure. He can now decide the market. Gold traders when interest rates move in The delta is simply the changewhen the underlying spot gold prices changes. Interest rate swaps in a nancial how to manage this delta risk. futures price change products price when the value of the underlyThe next example will illustrate this convalue change when underlying interest ing asset changes. For example, a bonds price cept. rates change. Equity options price change when the will change when interest rates move in the underlying equity price changes. market. Gold futures prices change when the Portfolio of bonds underlying spot gold prices change. Interest A dealer who makes a market by buying and However the change in the price selling financial instrument is not linear with the change in rate swap values change when the under- of the bonds will maintain a portfolio of them lying interest rates change.value.options at any given time. He faces the risk that the will not move by 1%. the underlying asset Equity If interest rates go up by 1%, bond prices prices change when the underlying equity bonds in his portfolio will change in price Moreover, bonds with different maturities and payoffs will move up ordifferently to the respond prices change. as the underlying interest rates changes the change in the price of nan- down. He wants to measure his delta expoHowever, in interest rates. cial instruments is not linear with the change sure, which will help him to decide whether How is Delta measured in practice? in the value of the underlying asset. If inter- or not to reduce the risk. A bonds delta is also If we try to conceptualise the delta with a graph (see Chart 1), the deltaFor simplyinterest ratesportfolio is con-a curve in Chart 3.In reality, the price of the Sayis simplicity, say his are as shown as simplied way. the current the estpractice, global bond prices will notuse a very simple technique to quantify delta risk. In rates go up 1%, market practitioners move known as its duration. steepness frequently di erent as bumping. First, the underlying assets price is 1%. Moreover, bonds with referred tothe price graph of a particular financial instrument. Note that the bonds: First, the dealer arranges his bond portfolio structed with three di erent nancial instrument does not move in a straight This method is (or gradient) of maturity Say measure two-year zero coupon as shown as a jumps by basis point periods and payo srepresented by a all financiallineto maturity are sensitivecash ow.Theorderofthe current interest rates assumes that interest ratesbe further1improved by will respond di Next straight instruments that buckets of to that erently according to measure its steepness. In 100 to Bond is the delta exposure, he are line. The delta cancurve in Chart 3. A: bumpedis now decimal point. curve by a small steepness to changes in interest rates. priced again with the newly bumped underlying assets These groups are then valued (or discounted) (0.01%), in parallel across all maturities. He will now re-value the cash flows using the bond measuring this convexity e ect. particular underlying asset is the price move of the financial instrument over newly bumped interestthe The delta is simply the change in the discounted value of cash measuredconceptualise the delta with a using the present underlying interest rates theIn of Bondto mof rate. the delta $5 by dividing price move easure If we try to 100 order B: three-year bond with exposure, he assumes that interest rates j price. The difference in the value of the financial instruments with the bumping is known as flows. Chart price change graph (see Chart asset. The more sensitive the particular financial instrument is to the 4 illustrates this. He now notices that the delta exposure is the biggest in the 3yearly coupon Conclusion underlying 1), it is simply the steepness in the market. the traders delta exposure. He can now decide how to manage this delta risk. 100 of Bond in parallel bond year(0.01%), maturity buckets. with $8 By knowing the delta, the dealer was the cas and 5-year C: five-year across all maturities. He will now re-value able of the underlying asset, the steeper its price curve will be and hence the yearly coupon larger the delta. interest rate. Themanageis simply the change in the di to delta the interest rate risk in his bond newly bumped The next example will illustrate this concept. His next bondis to manage the value risk,prin- portfolio. However, he now needs risk. Hetrack Each task has a nominal delta (or in this case, essentially his interest rate to keep will firstflows. Chart 4 illustrates this. He the keeps in the new portfolio, which will decide whether to keep the risk or not. If heof now notices that the he is of the does delta the risk, perhaps delta exposure cipal) of $100. Chart Portfolio of1: The Delta Chart 1: bonds Delta e The bond interest ratesmaturity buckets may go down in future which makes the view that the cash ow in at Year 3 and Year 5 consist of bonds and interest rate derivatives. year and 5-year maturity buckets. will look like the bondsIn the chart, we also We in a profit. Alternatively, he may not cash flows of Chart 2. increase in value, resulting will explore the delta in this expanded A bond dealer that makes a market by buying and selling bonds will maintain a portfolio of see the present value of the cash ow in each portfolio in the next article. think so and decide to reduce the risk. bonds at any given time. The dealer faces the risk that the bonds in his portfolio will change His bucket, discounted using current maturity next task is to manage the delta risk, in this case, essentially his in in price as the underlying interest rates move up or down. He wants to measure this delta interestreduce the delta by engaging in other financial instruments to offset the interest rate Jasvin Josen If he does keeps the risk, p He can rates. first decide whether to keep the risk or not.is an ex-investment banker exposure, which will help him next to decide whether or not to reduce this risk. A bond delta Say the common techniques are as shown, from Europe, specialising in risk.viewcurrent interest ratesare usingat Year 3 like interest ratemay govaluation and Most that the interest rates derivatives and Year 5 swaps, interest rate futur is also known as its duration. down in a curve, in Chart 3. To measure the delta ex- risk in financial derivatives. She is back forwards or interest rate futures. cash dealer of the bonds increase in value, providing in a profit. Alterna posure, theflowsassumes that interest rates in Malaysia,resultingconsultancy and First, he arranges his bond portfolio according to maturity buckets of cash flows. These jump one basis point (0.01%) in to reduce the risk. Readers can follow her at http:// Convexity so and decide parallel across training. grouped cash flows are then valued (or discounted) using the present underlying interest think all maturity periods. He will now revalue the derivativetimes.blogspot.com or send rates in the market. Readers may note that in Chart 1, a straight line instead of a curved Jasvin@souqmatters. cash ow using the newly bumped interest their comments to line represents the price He can reduce the delta by engaging change in delta is simply the change is a simplified way. In reality, the price of the rates. The the financial instrument. Thisin the com in other financial instruments to o For simplicity, say his portfolio is constructed with three different bonds: discounted value of cash ow.techniques are using derivatives like interest rate s risk. Most common Chart 4 illustrates this. The dealer now notices that the 100 of Bonds A : 2-year zero coupon bond forwards the biggest in rate futures. delta exposure is or interest the three-year 100 of Bonds B : 3-year bond with $5 yearly coupon and ve-year maturity buckets. His next task is to manage the delta risk, Convexity 100 of Bonds C : 5-year bond with $8 yearly coupon in this case, essentially his interest rate risk. He will rst decide whether or not to keep the Each bond has a nominal value (or principal) of $100. risk.Readers perhaps he isthat in Chart 1, a straight line instead of a curved li If he does, may note of the view that the interest rates the financial instrument. This is a simplified way. In reality, change in in Year 3 and Year 5 may go The bond cash flows in maturity buckets will look like Chart 2. In the chart we also see the down in the future, which makes the cash present value of the cash flows in each maturity bucket, discounted using the current interest ow of the bonds increase in value, resulting rates. in a prot. Alternatively, he may not think so Chart 2: Bond cash ow maturity buckets and decide to reduce the risk. He can reduce the delta by engaging in other financial instruments to offset the interest rate risk. The most common techniques are using derivatives like interest rate swaps, interest rate forwards or interest rate futures.

Maintaining a portfolio of financial instruments is an everyday thing for financial market nancial instruments is an Chart 3: Current Interest rate curve investors, everyday thing for financial and traders at commercial banks and investment banks. fund managers, dealers market investors, fund manJasvin Josen Hand in hand with maintainingat portfolio is managing the risk that theChart 3: Current Interest rate curve portfolio will incur agers, dealers and traders the commercial and investment losses from fluctuation in the securities prices in the portfolio. This is market risk.

Convexity

Readers may note that in Chart 1, a straight line instead of a curve represents the price change in the nancial instrument. This is a

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