Economics of Finance (U6022)

Homework Assignment #2
Tracking a Hedged Options Portfolio Over Time
Due: October 23, 2002

In this assignment, you will simulate a portfolio that consists of a long position in 100 T-
note futures call options and hedged with futures. You will rebalance the hedge every
day to stay delta-neutral.

Underlying security: December 2002 10-Year T-Note Futures

Strike: 115
Expiration: November 22, 20021
Option type: Call
Exchange: Chicago Board of Trade

Begin by collecting the call price and the futures price every business day. (The market
is closed on Monday October 14 for the Columbus Day holiday.) You can find the prices
in the New York Times or Wall Street Journal or the Chicago Board of Trade website.
We will only work with closing or “settlement” prices.

If you decide to use the CBOT website, go to www.cbot.com. Click on “Quotes and
Data” then “Financial Futures” then “Ten Year Treasury Notes”. We want the Settle
price for 02 Dec. If you want to do it all in one step, simply go to
http://www.cbot.com/cbot/quotes/fin_futures/0,1860,TY+9,00.html . A price like
“114260” means 114 + 26/32 = 114.8125. A price like “115225” means 115 + 22.5/32 =
115.703125. Next you need the options price. Click on Financial Options and follow
the links to 10 Year U.S. Treasury Note Calls for 02Dec. This will take you to
http://www.cbot.com/cbot/quotes/fin_options/0,1851,TC+2002Z,00.html . You want the
settle price for the 11500 strike. Options prices are quoted in points and 64ths. So 116
means 1+16/64 = 1.25.

Now you need to run the option through a Black-Scholes calculator. I would suggest:
http://www.intrepid.com/~robertl/option-pricer3.html (If you find a better one, please let
me know.)

Here is an example for October 11, 2002. The text in bold is what you enter.

Click the button for “volatility?”

What is the option price? 1.25

What is the stock price? 114.8125
What is the dividend yield? 0
What is the interest rate? 1.75
How long left to expiration? 42 (i.e., the days between Oct 11 and Nov 22)

1
Technically, the options expire on Saturday November 23. But our analysis will assume that the option
holder’s last exercise opportunity is Friday November 22, since the future market is closed on Saturdays.
Click the buttons “Expiration in days”, “Call option” and “European option?”

The program will automatically recalculate and you will see that

Implied volatility = 7.90%

Delta = .511
Gamma =0.129
Theta = -.017

Let’s look at the analysis as of the previous day, Thursday October 10:

What is the option price? 1.71875 (i.e., 1 +46/64)

What is the stock price? 115.703125 (i.e., 115 + 22.5/32)
What is the dividend yield? 0
What is the interest rate? 1.75
How long left to expiration? 43

In this case,

Implied volatility = 7.54%

Delta = 0.628
Gamma = 0.126
Theta = -.0165.

Imagine that you bought 100 calls at the closing price on Thursday October 10. You
would have paid 1.25. Remember, the units are $100,000 and price is quoted in percent,
so your cost per contract is 1.25 x 1000 = $1250. Since you are buying 100 calls, your
total cost is 100 x $1250 = $125,000. To hedge, you have to sell futures. The amount
you sell is delta x number of contracts = 0.628 x 100 = 62.8.2 On Friday, the T-note
futures price fell sharply as the Dow Jones rallied by 316 points. After one day, your
profit would be the sum of the loss on your calls and the profit on your hedge:

Options profit 100 x (1.25-1.71875) x 1000 = -46,875.00

Futures profit: 62.8 x (115.703125-114.8125) x 1000 = +55,931.25
Net profit: $9,056.25

Thus the portfolio earned a profit. You should not be surprised. Friday was a good day
to be long options, because the market moved by a lot. You would have captured a big
profit from your short hedge: the call delta dropped from 0.628 to 0.511, so you were
“overhedged” during the market’s decline. Moreover, implied volatility rose from 7.54%
to 7.90%, so the options became generally more valuable.

2
For the purposes of this assignment, we will assume you can buy or sell fractional contracts. In reality,
this is not possible.

2
At the end of trading on Friday, October 11, you need to reduce the size of your hedge.
According to the model, the delta has declined from 0.628 to 0.511. Thus you should buy
back 100 x (0.628 – 0.511) = 11.7 contracts. In order to stay delta neutral, you should be
short 51.1 futures contracts.

Your assignment is to track the hedge every day through the close of business on
Tuesday, October 22. Please create a table like this:

Profit and Loss from 100 T-Note Calls, Hedge Rebalanced Daily
Date 115 Calls Futures Delta Implied Hedge Options Total Cumulative
Volatility P&L P&L Daily P&L P&L

10-Oct-02 1.71875 115.703125 0.628 7.54

11-Oct-02 1.25 114.812500 0.511 7.90 $55,931.25 $(46,875.00) $9,056.25 $9,056.25
15-Oct-02
16-Oct-02
17-Oct-02
18-Oct-02
21-Oct-02
22-Oct-02

The Total Daily P&L is the sum of the change in your core call position plus the hedge
P&L. The hedge P&L comes from your short futures position. You have to adjust the
size of your futures position every day. The right-hand column is the sum of the daily
P&L since you initiated this trade on October 10.

This assignment will enhance your intuition on the Black-Scholes model and options
pricing.