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With the risk measures of Chapters 5 and 6 in hand, the focus now turns to dynamic risk management, that is, risk management that attempts that immunizes portfolio value from unexpected changes in the asset price, volatility, and interest rates, as well as the natural erosion of option’s time value as it approaches expiration. The chapter has two main sections. In the first, we tie the expected return/risk characteristics of options and option portfolios to the CAPM. In the second section, we consider the dynamic risk management problem faced by an option’s dealer, who in the course of business acquires an option position whose risk he needs to manage on a day-to-day (minute-to-minute) basis.

**7.1 EXPECTED RETURN AND RISK
**

7.1.1 Individual options

The key to understanding how options fit within the mean-variance CAPM is in the recognition of how an option’s expected return and risk are tied to the expected return and risk of the underlying asset. To develop those ties, recall that the rate of return of the asset may be expressed as RS = dS / S , and the rate of return on the call as Rc = dc / c . Thus, the relation between the call return and the asset return is

Rc =

dc dc S dS = × × = ηc RS c dS c S

(7.1)

where ηc is the call option’s eta or price elasticity.1 With the relation between the rates of return so defined, the variance of the call return is Var ( Rc ) = ηc2Var ( RS ) . The total risk,

which we have defined as the standard deviation of return, is therefore

1

The development of the expressions for the elasticity of option price with respect to the asset price, that is,

η c = ∆ c ( S / c ) and η p = ∆ p ( S / p ) , is contained in Chapters 5 and 6.

Derivatives: Markets, Valuation, and Risk Management Copyright © 2002 by Robert E. Whaley. All rights are reserved. Last revised: 09/08/02 at 11:19 AM 1

σ c =| ηc | σ S

and

(7.2a)

σ p =| η p | σ S ,

(7.2b)

for the call and the put, respectively, and the absolute value operator has been applied to ensure that the standard deviation is positive. Similarly, the option’s beta is defined as the covariance of the option’s return with the market return divided by the variance of the market return. Substituting the relation between option return and asset return (e.g., relation (7.1) for the call),

βc =

and

Cov( Rc , RM ) ηc Cov( RS , RM ) = = ηc β S Var ( RM ) Var ( RM )

(7.3a)

βp =

Cov( R p , RM ) Var ( RM )

=

η p Cov( RS , RM )

Var ( RM )

= η p βS .

(7.3b)

Note that since η p < 0 the beta for a put option is negative. This stands to reason since

the value of the put falls as the market rises, and vice versa. To better understand the expected return/risk characteristics of options, consider the following stock option illustration. Assume that the current stock price is 50, the expected stock return is 16 percent, the stock’s beta is 1.20, the volatility of the stock return is 40 percent, and the stock pays no dividends. Also assume that there exist 3month European-style call and put options with exercise prices of 45, 50, and 55, and that all of these options have prices equal to their European-style formula values from Chapter 5. The risk-free interest rate is assumed to be 4 percent. Using the risk relations (7.2) and (7.3) as well as the security market relation,

Ei = r + ( EM − r ) βi

(7.4)

from Chapter 2, the expected returns and risks of the different options are as summarized in Table 7-1. Note that we can use the security market line relation (7.4) to find the

2

implied expected return on the market, assuming the capital market is in equilibrium, that is, 16 = 4 + ( EM − 4)1.20 , or EM = 14% . The results in Table 7-1 are interesting in variety of respects. First, note the startling high values of the risk measures. The in-the-money call, for example, has a beta equal to 6.347 and a total volatility rate of 211.58%. This should not be surprising in the sense that call’s are nothing more that leveraged positions in the underlying asset. The implicit degree of leverage is given by the call’s eta. Owning the 45-call is like owning a portfolio in which you have placed 528.95% of your wealth in the stock and have borrowed an amount equal to 428.95% of your wealth. As we go from in-the-money calls to out-of-the-money calls, the degree of leverage increases and the risk measures go up. Figure 7-1 illustrates the expected return/beta tradeoff. Figure 7-2 shows the relation between expected return and volatility. A second noteworthy observation about the values reported in Table 7-2 (as well as Figures 7-1 and 7-2) is that put options have large negative expected returns. These, too, are leveraged positions, but this time the leverage goes the other way, that is, we are implicitly short selling stocks and placing the proceeds in the risk-free asset. The out-ofthe-money put in Table 7.1, for example, has an eta equal to -7.5594. This means that short selling an amount of stock equal to 755.94% of your wealth and using the proceeds, together with your initial wealth, to buy the risk-free asset has an expected return equal to the expected return of the OTM put,

−86.71% = −7.5594(16%) + 8.5594(4%) .

7.1.2 Option portfolios

The CAPM expected return/risk mechanics can also be applied to portfolios in order to analyze different trading strategies. A covered call strategy, for example, involves selling a call option for each unit of the underlying asset held. A protective put strategy involves buying a put for each unit of the asset held. To analyze these portfolios, expressions for the expected return and risks of the portfolio are needed. For portfolio consisting of the asset and an option, the expected portfolio return is

3

Eportfolio = XES + (1 − X ) Eo ,

(7.5)

the beta of the portfolio is

β portfolio = X β S + (1 − X ) β o ,

and the volatility of the portfolio is

(7.6)

σ portfolio = X σ S + (1 − X )σ o

for calls, and

(7.7a)

σ portfolio = X σ S − (1 − X )σ p

(7.7b)

**for puts.2 The proportion of wealth invested in the asset for the covered call strategy is
**

X= S . S −c

(7.8)

Note that the proceeds from writing the call are used to subsidize the cost of buying the asset in the denominator of (7.8). The proportion of wealth invested in the asset for the protective put strategy is

X= S . S+p

(7.9)

Since the put is purchased along with the asset, the sum of the prices appears as the investment cost in the denominator. Panel A of Table 7-2 contains the expected return/risk properties of the covered call strategies created from the call options listed in Table 7-1. To illustrate the computations, consider the ITM call. The expected return of the covered call strategy using the 45-call is

50 −7.0965 Eportfolio = 16% + 4% = 7.49% . 50 − 7.0965 50 − 7.0965 The beta of the covered call is

The expressions for portfolio for the call and put are different because, while both the returns of the call and put are perfectly correlated with the asset, the call returns are positively correlated and the put returns are negatively correlated.

2

4

**β portfolio = 1.20 + 6.347 = 0.349 50 − 7.0965 50 − 7.0965
**

and the volatility rate is

50

−7.0965

**σ portfolio = 40% + 211.58% = 11.62% . 50 − 7.0965 50 − 7.0965
**

In other words, a covered call strategy is risk-reducing. The further the call in in-themoney, the greater is the risk reduction, and the lower is this strategy’s expected return. Figure 7-3 shows the expected return/risk coordinates of the covered call portfolios using each of the calls in Table 7-1. Panel B of Table 7-2 summarizes the expected return/risk properties of the protective put trading strategies. Like writing calls against the stock, buying puts is riskreducing. The higher the put’s exercise price, the greater the risk reduction, and the lower the expected return. Figure 7-4 shows the expected return/risk attributes of the protective put strategies using each of the put’s in Table 7-1.

50

−7.0965

**7.2 MANAGING UNEXPECTED CHANGES
**

This section deals with the dynamic risk management of a portfolio of options. The most natural way to think about this process is to consider an option market maker on an exchange floor or an option dealer at a desk in a bank who, in the course of business, winds up with a portfolio of different option positions. While these positions are open, they may change in value with unexpected changes in asset price, the volatility rate, and/or the interest rate. To immunize the value of the overall position from these risks, the market maker uses dynamic hedging techniques. This section deals with the dynamic risk management problem.

**7.2.1 The general framework
**

In general, an options dealer may have as many as four types of instruments in his portfolio—options, the underlying asset, futures, and cash (bonds). The value of his portfolio is

5

V = ∑ ni Oi + nS S + B ,

i =1

N

(7.10)

where Oi is the price of option i, where there are N option series in his portfolio,3 S is the current asset price, and B is the value of the risk-free bonds. Note that, while futures contracts are in the portfolio, they involve no investment and, hence, do not contribute to portfolio value. To identify the change in value of the portfolio if risk attribute k changes, take the partial derivative of (7.10) with respect to k, that is,

N ∂O ∂V ∂S ∂F ∂B = ∑ ni i + nS + nF + , ∂k i =1 ∂k ∂k ∂k ∂k

(7.11)

where the futures price now appears because it may affect the change in the value of the portfolio. To find the change in portfolio value resulting from a change in risk attribute k, compute how each option value changes from a change in k, multiply by the number of contracts, and sum across all option positions. The asset price, the futures price and riskfree bond may also be affected by a change in k. Where k is the asset price, the delta of the portfolio is being measured. In this case, all of the deltas on the right-hand side of (7.11) are non-zero except for ∂B / ∂S . Where k is the risk-free rate of interest, the rho of the portfolio is being measured and all derivatives are non-zero. Where k is the volatility rate, the portfolio vega is being computed, and all partial derivatives on the right-hand side of (7.11) except ∂Oi / ∂σ are assumed to be equal to zero.4 Finally, equation (7.11) can be used to measure how the portfolio value will change as time passes. Chapter 5 contains expressions for the thetas of European-style call and put options. The prices of the futures and the risk-free bonds also change as time passes. Often second-order effects like gamma are also actively managed through time. The second derivative of (7.10) with respect to risk attribute k is, likewise, a weighted average of the individual components, that is,

Recall an option series has three identifying characteristics: (a) exercise price, (b) expiration date, and (c) call or put. 4 This assumption is made largely for convenience. In principal, a change in the volatility rate will affect the asset price and also the futures price. The mechanism for identifying the vegas of the asset price and the futures is the CAPM.

3

6

N ∂ 2Oi ∂ 2V ∂2S ∂2 F ∂2 B . = n + n + n + ∑ i S F ∂k 2 i =1 ∂k 2 ∂k 2 ∂k 2 ∂k 2

(7.12)

Where k is the asset price, the portfolio’s gamma is being measured. The gammas of the asset, the futures and the risk-free bonds are equal to zero. Once the risk measurements have been made, setting up the dynamic hedge is straightforward—decide which risk attributes of the unhedged portfolio should be negated and then identify a portfolio of hedge instruments (called the hedge portfolio) that has exactly the opposite risk attributes. When the two portfolios are combined, the hedged portfolio is risk-neutral. In general, one hedge security will be needed for each risk attribute. Hedging delta and gamma, for example, requires two securities. Hedging delta, gamma, and vega requires three.

Illustration 7-1: Hedge asset price risk.

Suppose a market maker in S&P 500 index options, as a result of accommodating customer orders to buy and sell, ends the day with the following positions:

No. of Option series contracts Exercise (C)all/ Days to (+ long/ price (P)ut expiration -short) 900 c 30 -100 950 c 30 -200 1000 c 90 -150 900 p 90 50 950 p 360 -100 1000 p 720 -200 1100 c 720 -100

Suppose also that, before the market closes, the market maker wants to hedge the delta risk of his position so that he is hedged if the S&P 500 index moves unexpectedly overnight. He is considering two alternatives—buying S&P 500 futures and buying 975-call options. The S&P 500 futures has 90 days to expiration, is currently priced at full carry, 1004.94, and has a delta of 1.0049.5

5

Recall that the futures delta is ∆ F = e

( r − d )T

.

7

The 975-call has 90 days to expiration and is currently priced at 55.432 and its delta is 0.635. Identify the number of contracts to sell in each case. Assume also that the S&P 500 index level is currently at 1,000, its dividend yield is 2%, and its volatility rate is 20%. The risk-free interest rate is 4%. The first step is to compute the overall risk characteristics of the portfolio. We will confine ourselves to delta, gamma, vega, and rho. The OPTVAL Function Library contains the necessary functions for computing the Greeks of each option series. Equations (7.11) and (7.12) are used to determine the aggregate exposures. The results are:

No. of Option series contracts Exercise (C)all/ Days to (+ long/ price (P)ut expiration -short) 900 c 30 -100 950 c 30 -200 1000 c 90 -150 900 p 90 50 950 p 360 -100 1000 p 720 -200 1100 c 720 -100 Portfolio

Value 10,196.59 11,367.74 6,271.21 -313.98 4,601.73 17,546.70 8,500.74 58,170.73

Delta -96.94 -165.61 -80.54 -6.12 31.76 74.87 -45.83 -288.41

Gamma -0.1154 -0.8831 -0.5966 0.1020 -0.1774 -0.2625 -0.1363 -2.07

Vega -1,896.45 -14,516.94 -29,423.39 5,028.22 -34,996.41 -103,560.06 -53,771.90 -233,136.93

Rho -7,129.19 -12,677.73 -18,311.65 -1,586.17 35,859.39 182,293.85 -73,630.18 104,818.32

The value of the portfolio is $58,170.73. The aggregate delta is -288.41, which means that for every point increase in the S&P 500 index, the portfolio will fall in value by 288.41. The aggregate gamma is -2.07, which means that, if the S&P 500 index moves up by one point, the delta of the option portfolio will fall by about 2.07. The aggregate vega is -233,136.93, which means that the market maker is short volatility.6 If the volatility rate moves up by 100 basis points, the portfolio value will fall by 2,331.37. The aggregate rho is 104,818.32 To hedge the delta exposure, futures can be purchased. Each futures has a delta of 1.005, so the number of futures needed to eliminate the delta risk is nF =

288.41 = 286.99 contracts. 1.0049

In practice, it is commonplace to find market makers short volatility because the trading public prefers to buy, rather than sell, options.

6

8

As the table below shows, the hedged portfolio delta is now equal to 0. Note that the value of the portfolio does not change because the futures requires no cash outlay. Likewise, none of the other risk attributes change.

No. of Option series contracts Exercise (C)all/ Days to (+ long/ price (P)ut expiration -short) Unhedged portfolio Hedge instruments F Hedged portfolio

Value 58,170.73

Delta -288.41

Gamma -2.07

Vega -233,136.93

Rho 104,818.32

90

286.99

0.00 58,170.73

288.41 0.00

0.00 -2.07

0.00 -233,136.93

0.00 104,818.32

A different delta hedge is possible using the 975-call with 90 days to expiration. Its delta is 0.635, so the hedge will require

n975 call =

288.41 = 453.98 contracts. 0.635

After the hedge is in place, the hedged portfolio delta is again 0, as is shown below. Note that using the 975-calls to hedge requires a payment of $25,165.31 to buy the options. In addition, buying the calls has affected the portfolio’s other risk attributes. Specifically, gamma and vega have fallen, and rho has increased.

No. of Option series contracts Exercise (C)all/ Days to (+ long/ price (P)ut expiration -short) Unhedged portfolio Hedge instruments 975 c 90 453.98 -25,165.31 33,005.43 288.41 0.00 1.7043 -0.37 84,049.44 104,818.32 Hedged portfolio -149,087.49

Value 58,170.73

Delta -288.41

Gamma -2.07

Vega -233,136.93

Rho 104,818.32

To understand how effective these hedges will be, consider the figure below, which shows the change in the value of the unhedged and hedged portfolios as the asset price moves in one direction of the other. The unhedged portfolio obviously has a negative delta. As the index level increase, portfolio value falls. For the hedged portfolios, this is not the case. As the index level moves by a small amount in either direction from its current level of 1000, portfolio value does not change. For large moves, however, the value of the portfolio falls. This is the 9

effect of the negative gamma of both hedged portfolio positions. The fact that the hedged portfolio value changes by less using the 975-calls to hedge rather than the futures is due to the fact that the 975-calls incidently reduced the portfolio’s gamma exposure.

Unhedged portfolio 20,000 10,000 Change in value 0 -10,000 -20,000 -30,000 -40,000 900 920 940 960 980 1000 Index level 1020 1040 1060 1080 1100 Hedged using futures Hedged using 975-calls

Illustration 7-2: Hedge delta and vega risk.

Suppose the market maker’s end-of-day position is as described in Illustration 7-1, and that, before the market closes he wants to hedge both the delta and vega risks of his position. To do so, he will use the S&P 500 futures and the 975-call options. Identify the number of each contract to buy or sell.

The optimal numbers of contracts to enter is identified by setting the number of contracts in the hedge portfolio in such a way that it has risk attributes equal in magnitude but opposite in sign as the unhedged portfolio. This means solving simultaneously the follow system of equations:

nF (1.0049) + n975 call (0.635) = 288.41 nF (0) + n975 call (185.14) = 233,136.93

.

10

Since the vega of the futures is assumed to be 0, only the call can be used to negate the unhedged portfolio’s vega-risk. The optimal number of calls to buy is

n975 call =

233,136.27 = 1, 259.27 . 185.14

The number of futures is then determined by

nF =

288.41 − 1, 259.27(0.635) = −509.06 . 1.0049

**The hedged portfolio risk exposures are now
**

No. of Option series contracts Exercise (C)all/ Days to (+ long/ price (P)ut expiration -short) Unhedged portfolio Hedge instruments F 975 c Hedged portfolio

Value 58,170.73

Delta -288.41

Gamma -2.07

Vega -233,136.93

Rho 104,818.32

90 90

-509.06 1,259.27

-0.01 -69,803.70 -11,632.97

-511.58 799.99 0.00

0.00 4.7275 2.66

0.00 233,136.93 0.00

0.00 180,045.24 284,863.57

To understand how the delta- and vega-risk of the portfolio have changed, consider the figures below. In the first, the gains/losses of the unhedged portfolio are shown. The unhedged portfolio is short the index and net short volatility. As the index level and volatility rate rise, the unhedged portfolio value falls. The effectiveness of the hedge instruments at controlling for delta and vega risk is shown in the second figure. For small changes in the index and/or the volatility rate from their current levels of 1000 and 20%, respectively, the hedged portfolio value does not change. Interestingly, portfolio value increases for large moves in the index in one direction or the other. The large position in the 975-calls has given the hedged portfolio positive gamma. Note also that, with large index moves, the hedged portfolio again becomes sensitive to vega risk, that is, it gains a short volatility exposure.

11

40,000 30,000 20,000 10,000 0 Changes in value -10,000 -20,000 -30,000 -40,000 -50,000 -60,000 1050 14% 18% 22% 26% 950 1000 Index level 900

10%

Volatility

Unhedged portfolio

40,000 30,000 20,000 10,000 0 Changes in value -10,000 -20,000 -30,000 -40,000 -50,000 -60,000 10% 14% 18% 1080 22% 26% 30% 1020 960 Index level 900

Volatility

Hedged portfolio

7.2.2 Practical considerations

Normally the market maker will have a variety of hedge instruments from which to choose. Presumably, in setting the hedge, he will want to minimize costs. One cost will 12

30%

be the trading costs associated with buying/selling the hedge instruments. Trading costs in exchange-traded futures and options markets are usually incurred on a per contract basis. Another cost is the opportunity cost of the funds tied up in the hedge instruments. In Illustration 7-2, for example, the 975-call options had to be purchased, which means that interest must be paid on the option premiums. Finally, options in the hedge portfolio erode in value as time passes.7 Depending on whether the market maker is short or long options, this may be a benefit or a cost. All of these benefits/costs can be measured, and the composition of the “least cost” hedge portfolio can be identified.

Illustration 7-3: Hedge delta and vega risk for one day.

Re-consider the market maker’s problem in Illustration 7-2. Suppose that the available hedge instruments are as follows:

Potential hedge instruments (F)utures/ Exercise (C)all/ Days to price (P)ut expiration F 90 975 c 90 975 p 90 1025 c 90 1025 p 90

Price 1,004.94 25.78 55.43 50.52 30.66

Assume the market maker pays a $5 per contract in trading costs and his borrowing/lending rate is 4%. Identify the least cost hedge portfolio assuming his hedging horizon is one day. First, use as many hedge instruments as you would like, and then use only two.

The market faces three costs over the hedge horizon. If trading costs were the only consideration, the market maker would simply find the delta/vega-neutral portfolio that minimized the number of contract. By here, he also needs to consider the opportunity cost of the funds in the portfolio as well as the erosion in time premium.

7

Options in the unhedged portfolio also erode in value, but that cost is sunk.

13

To begin, we need to identify the cost structure for each potential hedge instrument. The total commissions are simple—number of contracts times the $5 commission per contract. The interest cost is also straightforward. If options are sold, the market maker collects interest, and, if they are bought, interest is paid. To adjust for the interest income/expense, the option premiums (i.e., the number of contracts times the option price) are multiplied by e rT = e.04(1/ 365) . Finally, to adjust for the time erosion in option premiums, we compute the thetas of each hedge instrument.8 Since the interpretation of theta is the change in price as time to expiration increases, we must affix a minus sign in front. Also, since the rates are on annualized basis, we multiple the theta by 1/365 to determine the erosion in option value over a single day. The table below identifies the set of hedge instruments that minimizes the market maker’s costs. The use of Excel’s SOLVER greatly facilitates finding the solution quickly. The minimum cost hedge portfolio appears to contain only three instruments— the 975-call, the 1025-call, and the 1025-put. Virtually no futures or 975-puts appear. Note that since the option positions in the hedge portfolio are all long positions, interest is paid on the hedge portfolio value, and the hedge portfolio value decays with time. The total cost of the hedge for one day is $6,264.94.

No. of Option series contracts Exercise (C)all/ Days to (+ long/ price (P)ut expiration -short) Unhedged portfolio Hedge instruments F 975 c 975 p 1025 c 1025 p Hedged portfolio

Value 58,170.73

Delta -288.41

Vega -233,136.93

Theta 122.82

Trading costs

Interest cost

Time erosion

90 90 90 90 90

-0.11 39.13 0.00 913.12 245.65

0.00 -2,169.10 0.00 -27,993.66 -12,409.62 15,598.36

-0.11 24.86 0.00 400.39 -136.73 0.00

0.00 7,244.56 0.00 178,004.40 47,887.97 0.00

-2.16 -3,348.49 0.00 -79,078.69 -16,190.23 -98,496.75

-0.54 -195.65 0.00 -4,565.62 -1,228.27 -5,990.08 Total costs

-0.24 0.00 -3.07 -1.36 -4.67 6,264.94

-0.01 -9.17 0.00 -216.65 -44.36 -270.19

The SOLVER solution is wrong, however. The minimum cost hedge portfolio will consist of only two hedge instruments since there is only one pair of the five

8

Recall that the theta of the futures is θ F = ( r − i ) Se

( r −i )T

.

14

hedge instruments that will produce the minimum cost portfolio. To be certain which two, total costs should be computed for the 10 different pairings of the five instruments. Since it is unlikely that the futures or the 975-put will be contained in the least-cost portfolio, delete the futures and the 975-put from the set of feasible hedge instruments and re-run SOLVER. SOLVER now eliminates the 975-call, and total hedge costs are about $10 less.

No. of Option series contracts (+ long/ Exercise (C)all/ Days to price (P)ut expiration -short) Unhedged portfolio Hedge instruments 975 c 1025 c 1025 p Hedged portfolio

Value 58,170.73

Delta -288.41

Vega -233,136.93

Theta 122.82

Trading costs

Interest cost

Time erosion

90 90 90

0.00 958.78 237.16

0.00 -29,393.47 -11,980.36 16,796.90

0.00 420.41 -132.00 0.00

0.00 186,905.42 46,231.51 0.00

0.00 -83,032.98 -15,630.20 -98,540.36

0.00 -4,793.92 -1,185.79 -5,979.70 Total costs

0.00 -3.22 -1.31 -4.53 6,254.55

0.00 -227.49 -42.82 -270.31

7.3 SUMMARY

This chapter deals with dynamic risk management, that is, risk management that attempts to account for short-term movements in the asset price, volatility, and interest rates, as well as the natural erosion of option’s time value as it approaches expiration. The chapter has two main sections. In the first, we tie the expected return/risk characteristics of option portfolios to the CAPM. Like futures contracts, options fit within the framework. In the second section, we consider the dynamic risk management problem faced by an option dealer, who in the course of business acquires an option position whose risk he needs to manage on a day-to-day (minute-to-minute) basis.

15

Questions

1) State whether the claim is true, false, or uncertain and give an explanation. a) The beta of a call option equals the call’s eta times the underlying asset’s beta. b) The standard deviation of a put option’s return equals the put’s eta times the stand deviation of the underlying asset’s return. c) Futures contracts can be useful in hedging the gamma risk of a portfolio. d) The gamma risk of a portfolio can be altered by changing the number of units of the underlying asset held in the portfolio. e) The rho-risk of a futures contract equals zero.

16

Problems

1) Expected return/risk of option portfolios. Compute the expected rate of return ( E p ) and risk (both β p and σ p ) of a portfolio that consists of buying an at-the-money protective put against a long position in the asset. Assume the asset price (S) is 50, the expected rate of return on the asset ( E S ) is 12%, the asset beta ( β S ) is .75, and the volatility of the asset return (σ S ) is 40%. The risk-free rate of interest is 6%. The 50 put is European-style, has three months remaining to expiration, has a price of 3.701, and has a delta value of -.438. 2) Expected return/risk of option portfolios. Currently, you have $50 invested in an asset whose expected rate of return is 20%, beta ( β S ) is .50, and volatility of return ( σ S ) is 50%. Suppose that you are considering writing a call option against this asset investment. The call is European style, has an exercise price of 50, and has two months remaining until expiration. Furthermore, it is priced at 2.50 and has a delta of .25. The proceeds from selling the call will be used to buy more units of the asset. The risk-free rate of interest is 8%. a) Find the call option’s elasticity with respect to asset price, its expected return, its beta, and its standard deviation of return. b) For the covered call option portfolio, find the proportion of your wealth invested in the asset and the call, and then find the portfolio's expected return, beta, and volatility of return. c) Using the call option’s delta, derive the composition of a portfolio whose expected return, beta, and volatility attributes match those in part (b) but whose composition consists of only the asset and T-bills. 3) Expected return/risk of option portfolios. Currently, you have $50 invested in an asset whose expected return is 20%, beta is .5, and volatility is 50%. Suppose that you are considering writing a call option against this asset. The call is European-style, has a 50 exercise price, and has two months to expiration. Furthermore, it is priced at 2.50 and has a delta of .25. The proceeds from selling the call will be used to buy more units of the asset. The risk-free rate is 8%. a) Find the call’s price elasticity with respect to the underlying asset, its expected return, its beta, and its standard deviation of return. b) For the covered call option portfolio, find the proportion of your wealth invested in the asset and the call, and then find the portfolio’s expected return, beta, and volatility. c) Using the call option’s delta, derive the composition of a portfolio whose expected return, beta, and volatility match those of the portfolio in b) but whose composition consists of only the asset and T-bills.

17

4) Hedging with futures and calls. Assume a futures option market maker has a long position of 200 calls with an exercise price of 45, and short positions of 80 puts with an exercise price of 50, and 50 calls with an exercise price of 55. Rather than face the risk that the underlying futures price or futures return volatility may shift significantly over the weekend, he decides to make his portfolio delta-risk and vega-risk neutral using futures and the call with an exercise price of 50. The current futures price is 50, the 50-call has a price of 2.455, a delta of .517, and a vega of 9.806. The interest rate is 6%, and the volatility rate is 25%. The composition of the market maker’s current portfolio as well as the characteristics of the individual options are given below: Option type call put call Exercise price 45 50 55 Option Price 5.575 2.455 .828

Quantity 200 -80 -50

Delta .805 -.468 .238

Vega 6.521 9.806 7.690

Compute the number of futures and 50-calls to immunize the portfolio from movements in the futures price and the volatility rate.

5) Minimization of transaction costs. Assume a futures option market maker is short (a) 60 puts with an exercise price of 390, (b) 50 calls with an exercise price of 420, and (c) 20 futures contracts. Rather than face the risk that the underlying futures price may shift significantly over the weekend, he decides to make his portfolio delta- and gamma-neutral using futures and either the 400 call or the 400 put. The current futures price is 400, the interest rate is 6%, and the volatility rate is 25%. Current option values and their “Greeks” are as follows:

Exercise Price 380 390 400 410 420 Value 27.466 21.250 16.009 11.737 8.371 CALL OPTION Delta Gamma 0.704 0.008 0.612 0.009 0.515 0.010 0.419 0.010 0.330 0.009 Vega 54.867 61.237 63.982 62.883 58.390 PUT OPTION Value Delta Gamma 7.662 -0.286 0.008 11.348 -0.378 0.009 16.009 -0.475 0.010 21.638 -0.571 0.010 28.174 -0.660 0.009 Vega 54.867 61.237 63.982 62.883 58.390

Assume that the market maker wants to minimize transaction costs and that the transaction cost rate is $10 per contract, how many futures and option contracts should be bought/sold? 6) Delta and gamma hedging. A stock option market maker has a portfolio consisting of 200 shares of XYZ Corp.(a non-dividend paying stock), and the following option positions on XYZ Corp: (Each option is assumed to be written on a single share of the stock.)

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Quantity -125 50 75

Option Type Call Call Put

Exercise Price 60 45 55

Option price .309 6.38 5.00

Delta .108 .857 -.705

Gamma .030 .036 .055

The market maker is worried about stock price movements in XYZ's stock over the weekend and would like to make his portfolio both delta-neutral and gamma-neutral over the weekend. The current price of XYZ stock is $50.00, the volatility of the stock is 25%, and the rate of interest on the T-bills is 8%. The market maker can form the hedge using a futures on XYZ stock whose price is $52.00 and either one of two options on XYZ stock whose attributes are: Option type Put Call Exercise price 60 50 Option Price 9.121 2.994

Delta -.892 .588

Gamma .030 .062

How many futures and option contracts should be bought/sold if transaction costs are $10 per contract?

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Table 7-1: Expected returns and risks of European-style options written on a stock. Stock price is 50, expected stock return is 16%, stock beta is 1.20, volatility rate is 40%, and dividend yield is 0%. Interest rate is 4%, and expected return on market is 14%. Options have 3 months remaining to expiration.

Exercise price 45 50 55 45 50 55 (C)all/ (P)ut c c c p p p Expected return 67.47% 83.63% 100.83% -86.71% -67.05% -51.76% Total risk 211.58% 265.43% 322.77% 302.38% 236.82% 185.86%

Moneyness ITM ATM OTM OTM ATM ITM

Value 7.0965 4.2167 2.3051 1.6487 3.7192 6.7578

Delta 0.7507 0.5596 0.3720 -0.2493 -0.4404 -0.6280

Eta 5.2895 6.6358 8.0693 -7.5594 -5.9205 -4.6465

Beta 6.347 7.963 9.683 -9.071 -7.105 -5.576

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Table 7-2: Expected returns and risks of covered call and protective put trading strategies. Stock price is 50, expected stock return is 16%, stock beta is 1.20, volatility rate is 40%, and dividend yield is 0%. Interest rate is 4%, and expected return on market is 14%. Options have 3 months remaining to expiration.

A. Covered call strategies Moneyness ITM ATM OTM Exercise price 45 50 55 X 1.165 1.092 1.048 Expected return 7.49% 9.77% 11.90% Beta 0.349 0.577 0.790 Total risk 11.62% 19.24% 26.33%

B. Protective put strategies Exercise Moneyness price OTM 45 ATM 50 ITM 55

X 0.968 0.931 0.881

Expected return 12.72% 10.25% 7.93%

Beta 0.872 0.625 0.393

Total risk 29.07% 20.83% 13.11%

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Figure 7-1: Expected return/beta relation of European-style options written on a stock. Stock price is 50, expected stock return is 16%, stock beta is 1.20, volatility rate is 40%, and dividend yield is 0%. Interest rate is 4%, and expected return on market is 14%. Options have 3 months remaining to expiration.

125% OT M call AT M call IT M call

75%

Expected return

25%

stock risk-free asset 0 5 10 15

-15

-10

-5

-25%

IT M put AT M put -75% OT M put -125% Beta

22

Figure 7-2: Expected return/volatility relation of European-style options written on a stock. Stock price is 50, expected stock return is 16%, stock beta is 1.20, volatility rate is 40%, and dividend yield is 0%. Interest rate is 4%, and expected return on market is 14%. Options have 3 months remaining to expiration.

125% OT M call 75% AT M call IT M call

Expected return

25%

stock risk-free asset 0% 50% 100% 150% 200% IT M put 250% 300% 350%

-25%

-75%

AT M put OT M put

-125% Volatility

23

Figure 7-3: Expected return/volatility relation of covered call strategies. Stock price is 50, expected stock return is 16%, stock beta is 1.20, volatility rate is 40%, and dividend yield is 0%. Interest rate is 4%, and expected return on market is 14%. Options have 3 months remaining to expiration.

20% 18% 16% stock

Expected return

14% 12% 10% 8% 6% 4% 2% 0% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Volatility risk-free asset IT M call AT M call OT M call

24

Figure 7-4: Expected return/volatility relation of protective put strategies. Stock price is 50, expected stock return is 16%, stock beta is 1.20, volatility rate is 40%, and dividend yield is 0%. Interest rate is 4%, and expected return on market is 14%. Options have 3 months remaining to expiration.

20% 18% 16% stock OT M put AT M put IT M put

Expected return

14% 12% 10% 8% 6% 4% 2% 0% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Volatility risk-free asset

25

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