Professional Documents
Culture Documents
ISSN 2217-8090
UDK: 336.761; 005.334
DOI: 10.5937/sjas11-5820
Review paper/Pregledni naučni rad
Jelena Paunović1,*
1
Wiener Städtische osiguranje a.d.o. Belgrade
1 Trešnjinog cveta Street, Belgrade, Serbia
Abstract:
Options are financial derivatives representing a contract which gives the
right to the holder, but not the obligation, to buy or sell an underlying
asset at a pre-defined strike price during a certain period of time. These
derivative contracts can derive their value from almost any underlying
asset or even another derivative: stock-options, options on bonds, swap
options (options on swaps), weather options, real options and many others.
Options have existed for a long period of time but they became widely
popular after Fisher Black, Myron Scholes and Robert Merton developed
a theoretical pricing model in 1973 known as the Black–Scholes model.
Options became a standardized product traded on the Chicago board
of options Exchange (CBOT) through the clearing house guarantees. Key words:
Nowadays, options are both market and OTC (over the counter) traded
financial derivatives,
and are mainly used for portfolio hedging and speculation.
OTC market,
In this paper I am going to study market risk management from the
hedging,
perspective of options trader, and I will show how to describe the risk
characteristics of plain vanilla European stock options contracts by go- risk,
ing through the “Greeks” which are defined as quantities that represent speculations,
option’s sensitivity to risk. Finally, I will construct portfolios that will Black–Scholes model,
eliminate these risks. Greeks.
If we consider all the above - mentioned assump- is the “hedge ratio” delta and it gives the number
tions, their model allows us to solve the price of the of shares of the stock to hold at time t in order to
option in a particularly elegant way. replicate the call.
Six factors are affecting the price of an option: The key variable which determines the option
◆ the spot price of the stock at the moment T price is volatility, σ.
denoted as St. The strike and the maturity are determined by
◆ the Exercise or strike price denoted as K, at the contract, the underlying asset price is monitored,
which the financial security can be bought or and the risk free rate is easily approximated by, for
sold. instance, LIBOR or by the overnight interest rate
swap. Certainly, Black–Scholes options prices are
◆ the option expiration time denoted as T.
not what we shall see in the market. If the model was
◆ the Volatility of the underlying stock denoted entirely correct, options with the same expiration
as σ. date for the same stock would have the same implied
The option price is a function of all these vari- volatility which is not to be encountered on the mar-
ables so the European call can be written as follows: ket. However, the traders use the implied volatility
Call Price = C(S(t),K,T,r,σ). to calculate the price of options. The observed rela-
The Black–Scholes formula for the value of a Euro- tion between the implied (Black and Scholes,1972)
pean call option on a non-dividend paying stock is volatility and the strike price for a given maturity is
given by (Kolb, 2003): called the volatility smile. The relation between the
implied volatility and maturity for a given strike is
c BS ( St , K ,=
T , r , σ ) St N ( d1 ) − Ke N ( d 2 ) . (1)
− r (T − t )
called the structure of volatility.
N(x) is the probability that a N (0, 1) random We’ve just had a quick reminder of the Black–
variable is less than x, and Scholes model and its assumptions; so we are now
ready to start analyzing risk exposures and the char-
ln( St / K ) + (r + 0.5σ 2 )(T − t )
d1 = , (2) acteristics of the main risks associated with a more
σ T −t complex portfolio of underlying stock positions.
ln( St / K ) + (r + 0.5σ 2 )(T − t )
d2 = OPTIONS AND RISK MANAGEMENT
σ T −t
d1 − σ T − t .
d2 = (3) The following example will be used throughout
this paper:
Ln is the natural logarithm; σ is the volatility of Let’s suppose we are trading options for J.P. Mor-
the continuously compounded return of the stock. gan and we write an (at-the-money) European call
If we re-write for $5 with T=10 weeks. The underlying stock is
c BS ( ST , K ,=
T , r , σ ) N ( d1 ) St − Ke − r (T −t ) N ( d 2 ) (4) traded at $50, sigma=50%, and the risk-free rate is
∆ B 3%. The Black–Scholes model gives us the price of
the call option: $4.5.
as c BS
( St , K , T , r , σ ) =∆St + B , (5)
In order to make a risk-free $0.5 profit we could
we can see a similarity to the one-period replication buy the same option for $4.5 elsewhere or spend $4.5
model of the binomial trees. on a replicating portfolio (by buying a synthetic op-
tion for example) that has the same payoff.
Actually, the Black–Scholes is derived by no ar-
bitrage (Mullaney, 2009), as it replicates an option This is possible in theory, however, in practice,
by a dynamic portfolio of a stock and a bond. It is perfect replication of the option’s payoff is not real.
the limit to the binomial model when the number We cannot perfectly hedge all the risk associated with
of branches goes to infinity. The detailed derivation the call we have just written.
of the Black–Scholes model and the binomial tree That could be done if the binomial tree model
model falls out of the scope of this paper. We can perfectly described the stock price dynamics (which
see from what is given above that the call option is not the case in the real world) and if we traded
can be replicated by buying a delta amount of stock without transaction costs (which is also impos-
and by selling B amount of bonds. In this case N (d1) sible).
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SJAS 2014 11 (1) 74-83
Paunović J. Options, Greeks, and risk management
Then, they form an approximate replicating port- and we can see that
folio for the written call option. The value of this
∆ c → 0 as S → 0 and ∆ c → 1 as S → ∞ .
portfolio should change by about the same amount
A delta of a call option typically looks like the
as that of the option (at least for small changes in
graph given in the following chart (Hull, 2002):
the factors). In order to determine how sensitive the
options are to the particular risk source one should
look at the “Greeks” options (Hull, 2002) - quanti-
ties denoted by Greek letters representing options’
sensitivities to risk. They are the key to options risk
management.
THE “GREEKS”
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SJAS 2014 11 (1) 74-83
Paunović J. Options, Greeks, and risk management
The Gamma describes the derivative’s convexity The Theta describes a derivative’s sensitivity to
and is given by: the time to maturity (T). It captures the time-de-
∂∆ c ∂d1 N '(d1 ) cay and it is given by the following formula using
Γ=
c = N '(d1=
) > 0 . (9) Black–Scholes:
∂S ∂S Sσ T − t
∂c −∂
The Gamma of the call option is always equal to Θc = = ( SN (d1 ) − Ke − r (T −t ) N (d 2 ))
∂t ∂ (T − t )
the gamma of the put:
−∂ (−d1 ) ∂N (d1 ) ∂N (d 2 )
Θc =− S + Ke − r (T −t ) − rKe− r (T −t ) N (d 2 ) . (11)
Γp = N '(− d1 ) =Γ c . (10) ∂ (T − t ) ∂ (T − t )
∂S
We can see that When simplified, it becomes:
Γ → 0 as S → 0 Γ → 0 as S → ∞ , T −t )2 /2
Se − ( d2 +σ
Γ is high when S ≈ K . SN '(d1 ) =
2π
In fact, Gamma tells us how much delta we gain
as the underlying stock rises. It also reveals another
= SN '(d1 ) SN ='(d 2 )e
− σ T −t )d 2−σ 2(T −t )/2
Ke− r (T −t ) N '(d 2 ) , (12)
important thing and that is by how much a delta-
hedged derivative becomes unhedged (Ross et al.,
and with
2012a). We’ll deal with this in further details at the
end of the paper when we’ll be building hedging ∂ (d1 − d 2 ) ∂ (σ T − t ) σ
portfolios. = = . (13)
∂ (T − t ) ∂ (T − t ) 2 T −t
A gamma of a call option typically looks like the
graph given in the following chart: Taking them together we get:
− N '(d1)σ S
=Θc − rKe − r (T −t ) N (d 2 ) < 0 . (14)
2 T −t
∂ (C − f ) ∂f
Θp = =Θc +
∂t ∂ (T − t )
− N '(d1)σ S
=Θp + rKe − r (T −t ) N (− d 2 ) . (15)
2 T −t
The Vega describes the option’s sensitivity to the The Rho describes the option’s sensitivity to the
volatility of the underlying stock and is given by: risk free interest (Natenberg, 1994) rate changes and
is given by:
∂C
υc = =S T − t N '(d1 ) > 0 , (16) ∂
∂σ =pc ( SN (d1 ) − Ke− r (T −t ) N (d 2 ))
∂r
∂p ∂N (d1 ) ∂N (d 2 )
υ
= = υc . =pc S − Ke − r (T −t ) + (T − t ) Ke − r (T −t ) N (d 2 ). (18)
p
∂σ (17) ∂r ∂r
Now we have:
We can easily see that:
∂N (d1 ) ∂d1
υ≈0 for S<K, = N '(d1 ) , (19)
∂r ∂r
ν is the largest for S≈Ke-r(T-t),
and
υ≈0 for S>K .
∂N (d 2 ) ∂ (d1 − σ T − t ) ∂d1
= = N '(d 2 ) N '(d 2 ) , (20)
∂r ∂r ∂r
The Vega is really valuable because the Black– and
Scholes model is assumes/implies constant volatil-
ity. Volatility traders use complex statistical models SN '(d1 ) = Ke − r (T −t ) N '(d 2 ) , (21)
(ARIMA, GARCH etc.) to predict the options implied
volatility and thus make decisions if an option is so finally we get:
over or under-valued (Fontanills, 2005). The Vega (T − t ) Ke − r (T −t ) N (d 2 ) > 0 .
pc = (22)
of a call option typically looks like the graph given
in the following chart:
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SJAS 2014 11 (1) 74-83
Paunović J. Options, Greeks, and risk management
∂V ∂A ∂A ∂A
= n1 1 + n2 2 + n3 3 . (26)
∂x ∂x ∂x ∂x
∂V ∂A ∂A ∂A
= n1 1 + n2 2 + n3 3 = 0 . (27)
∂x ∂x ∂x ∂x
DELTA HEDGING
However, in order to do this hedge it should not denoted as P* (Bodie et al., 2010b) which is equivalent
be forgotten that it takes 3 assets to form such port- as if we said that the portfolio is Gamma neutral:
folio. P* = C − P∆ ∆ c − Pp pc − PΘ Θc
and
Each one of these risk exposures has its own price p p* = 0 .
(Passarelli, 2012). The simplest example would be to
price the cost of a unit exposure to delta. In order to get the price of gamma we have to
◆ As the underlying stock S is a pure exposure solve the following equation:
to delta, one unit of delta would then cost the N '(d1 )σ S
price of the underlying stock S(t).
p * 2r (T − t ) σ 2 S 2
◆ If we want to price the Rho (Chen and Se- = =
Γ p* N '(d1 ) 2r
bastian, 2012), its value would be zero as the
duration costs nothing. Sσ (T − t )
Proof: The Greeks of a bond are:
σ S
2 2
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SJAS 2014 11 (1) 74-83
Paunović J. Options, Greeks, and risk management
which is equivalent to: Carter, J.F. (2012). Mastering the trade: Proven tech-
1 niques for profiting from intraday and swing trading
rV = rSCs + σ 2 S 2Css + Ct . (43) setups. New York: McGraw Hill Professional.
2
Chen, A.D., & Sebastian, M. (2012). The option trader’s
We can see from the above given, that ultimately hedge fund: A business framework for trading equity
we get the Black–Scholes partial differential equation and index options. Upper Saddle River, N.J: FT Press.
(Ianieri, 2009) that governs the price dynamics of Cohen, G. (2005). The bible of options strategies: The defini-
any derivative. tive guide for practical trading strategies. Upper Saddle
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Cottle, M.C. (2006). Options trading: The hidden reality:
CONCLUSION
Ri$k Doctor guide to position adjustment and hedging.
Chicago: RiskDoctor.
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ket. In Serbia, it is currently at an initial stage and its stress trading methods. Hoboken, N.J: John Wiley &
main purpose will be to allow investors to hedge the Sons.
existing positions and minimize the risk exposure. Hull, J.C. (2002). Options, futures, and other derivatives
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have to fully understand “Greeks” options which are Hull, J.C. (2011). Student solutions manual for options, fu-
defined as the quantities that represent sensitivities tures, and other derivates (8th ed.). Upper Saddle River,
of the option’s price to a particular source of risk. N.J: Pearson Prentice Hall.
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life examples on how the Greeks could lead to a more Wiley.
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Rezime:
Opcije su finansijski derivati koji predstavljaju ugovor koji daje pravo vlasniku,
ali ne i obavezu, da kupi ili proda određenu aktivu po ugovorenoj ceni izvršenja u
toku određenog vremenskog perioda. Derivatni ugovori mogu da dobiju vrednost
od skoro svake određene aktive ili čak drugih derivata: postoje opcije na akcije,
opcije na obveznice, opcije na svopove, vremenske opcije, prave opcije i mnoge
druge. Opcije postoje duži vremenski period, ipak postaju popularne nakon što su
Fisher Black, Myron Scholes and Robert Merton razvili teoretski cenovni model
poznat kao Black–Scholes model.
Ključne reči:
Opcije postaju standardizovan produkt trgovine na Čikaškoj berzi opcija (CBOT)
finansijski derivati,
posredstvom garancije klirinske kuće. Danas, opcijama se trguje na berzama ili
van-berzanski (OTC ) i one se uglavnom koriste za portfolio hedžing i spekulacije. OTC tržište,
hedžing,
U ovom naučnom radu akcenat je stavljen na tržišno upravljanje rizikom posma-
trano iz ugla trgovaca opcijama, kao i na opis karakteristika rizika plain vanilla rizik,
Evropskih opcionih ugovora putem “Greeks” kvantitativa, koji predstavljaju spekulacije,
opcionu osetljivost na rizik. Na kraju rada konstruisan je portfolio koji će ukloniti Black–Scholes model,
navedene rizike. Greeks.
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