Chapter 6

Option Greeks
Swaps
1 Seeing Options sensitivity to different variable
· 2Delta/Theta/Vega & Gamma risks of options
·3 Understanding option Greeks for various trading strategies (volatility & Directional
Spreads)
4 Delta /Dynamic Hedging and relating the cost of Delta hedging with the option price
determined by Black & Scholes – Model.
5 Elasticity (Beta) of an option in the CAPM framework.
6 Swaps –

1
 1 Option Sensitivity
Option Greeks determine the - Change of the value
●

of an option to different variables

The 5 Option Greeks measure the sensitivity of the price
●

of stock options in relation to various different factors like-

● Changes in the underlying stock price,
● interest rate,
● volatility,
● time decay.

2
 1 Option Sensitivity
Option Greeks determine the - Change of the value
●

of an option to different variables

The 5 Option Greeks measure the sensitivity of the price
●

of stock options in relation to various different factors like-

● Changes in the underlying stock price,
● interest rate,
● volatility,
● time decay.

3
 1 Option Greeks
Trading options without an understanding of the
●

Greeks - the essential risk measures and

profit/loss in options strategies- extremely risky

4
 2 Option Greeks for Trading
Option prices changes when basic pricing
variables change. The option price is based on
various factors such as
● Stock price
● Strike price
● Price volatility
● Time to expiration
● Interest rates
5
 1 Option Greeks -Delta
●Delta is changes in option prices relative to
change in stock price( direction of movement up
or down)
●An increase in the underlying stock price causes
the call value of an option to increase and its put
value to decrease, other factors being unchanged.
●The change in option premium that is due to
change in stock price is called option Delta.
● Delta= C
6
● S
 Option Greeks -Delta
C is the change in the option price
● S is the change in the price of underlying stock.
Delta values range between 0 and 1 for call
●

options and -1 to 0 for put options.

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 Option Greeks -Delta
Call Options
●When the underlying stock or futures contract increases in price,
the value of the call option will also increase by the call options delta
value.
●On the other hand, when the underlying market price decreases,
the value of the call option will also decrease by the amount of the
delta.
Put Options
●

When the market price of the underlying asset increases, the value
●

of the put option will decrease by the amount of the delta value.
●Conversely, when the price of the underlying asset decreases, the
value of the put option will increase by the amount of the delta
value. 8

Put options have negative deltas, which range between -1 and 0.

●
 VALUE OF AN OPTIONS
In the money Out of the money
When exercise price is below the currentFor a call option:
price of the underlying asset
●Spot price < strike price
For a call option:
●
●Spot price>strike price

●For a put option:

●For a put option:

●Spot> strike price

●Spot price < strike price

● At the money
● Spot price = strike price
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 2 Option Greeks -Gamma
●Option gamma, often expressed using the Greek letter Γ, is a
mathematical tool used in the option theory to explain the
relationship between the value of an option and the price of the
underlying asset.
●If the gamma is small, the delta changes slowly, but if the gamma
is large , then the delta is highly sensitive to the price of the
underlying asset.
When close to expiration the gamma value goes to 0.
●

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 2 Option Greeks -Gamma
●Option gamma changes as the underlying asset price
changes.
● Option gamma is highest for options at-the-money.
●Any change, even a small one, in the price of the underlying
asset affects the value of the option significantly.
● This is the point at the top of the curve on the picture below.
●Gamma is lowest when an option is deeply in-the-money or
completely out-the-money.
●Any change in the price of the underlying asset has little or
no effect on the option value.
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 2 Option Greeks -Gamma
●A high gamma is less attractive to the option
seller because because as the option moves into
the money, the delta increases at a faster pace,
increasing the sellers losses.
●Since changes in the delta are always against
option seller, a high gamma goes against the
seller.
A high gamma is more beneficial to option
●

buyers.
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 3 Theta
●Change in the value of an option with respect
to time to expiration
The time to expiration is also called time to
●

maturity
●The longer the options time to expiration , the
more valuable the option , if other factors are kept
constant
As the time to expiration approaches the option
●

becomes less valuable

13
●
 3 Theta
The value of the theta lies between 0 and the total value
●

of the option
●As the option approaches expiration the theta increases
in value, which means the time value of the option erodes
more quickly towards expiration
A high theta is attractive to option writers since such
●

options have high rate of time decay

The value of option is highest when option is in the
●

money
Theta is usually negative for an option since the time to
●

maturity decreases the option tends to be less valuable. 14

 3 Theta
Option theta is a function of time and value of the underlying
●

asset.
The time value of either a call or put option decreases as the
●

option approaches its expiration.

Theta is the same for call and put options.
●

●Option theta is minimal (or maximal when looking at its absolute

value) when an option is at-the-money.
Option theta - its absolute value - increases as the option
●

approaches its expiration.

Option theta is usually negative. European put option in-the-
●

money is an exception to the rule. Such an option can have a

positive theta. 15
 3 Theta
● Option theta is negative because the relationship
between option's value and the time to expiration
is inverse. As the option ages, the time value
decreases.

16
 4 Vega or Lambda
Lambda or vega is the change in an options price
●

with respect to the percentage change in volatility

of the options underlying stock or index
● The value of lambda lies between 0 and infinity
The value declines as the option approaches
●

maturity
●If the lambda is high the options value is very
sensitive to small changes in volatility

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 4 Vega or Lambda
Option vega is similar for call and put options.
●

●Options with short time to expiration have lower option vega than
long time before expiration.
This is so because long-term options are exposed to a greater risk
●

of ending out of the money then options with only a few days to
expiration.
●The price of the underlying asset is more likely to go 50% up or
down in long term than in short term.
Options are most sensitive to changes in the volatility of the
●

underlying asset when they are at-the-money.

●Options out-the-money and in-the-money are not affected by
volatility in the prices of the underlying assets. 18

Option vega can be hedged with another option only.

●
 4 Vega or Lambda
A low lambda indicates that volatility changes
●

have very little impact on the value of the option

A lambda is at its maximum value at the money
●

with a long time for expiration

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 5 Rho
●Changes in option price with respect to interest
rate
●It measures the sensitivity of the option to
changes in interest rate
● The relationship is always positive
The options values can be ascertained from an
●

option calculator

20
Factors affecting Option Price

21
 5 Rho
●For call option , one wants the underlying price to increase, so one
can get more money on exercising the option .
If the interest rate is high u will get more return as you will
●

have more money to invest.

●For put option, you want underlying to fall, If you own a put option
and the stock price is LOWER than the strike price, then it makes
sense for you to exercise your put.
●Interest rate falls , put will be exercised ----A stock put option
becomes an early exercise candidate anytime the interest that
could be earned on the proceeds from the sale of the stock at the
strike price is large enough.

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 5 Rho
● For dividend-
●Dividend is given to share holder
NOT option holder. So one will ● For call premium increases
have to exercise the option to get ● As interest rates rise, call
the dividend. premiums will increase and put
●If dividend is high, call option value premiums will decrease.

falls as the chances of it getting ●This is because of the costs

exercised in the market increases. associated with owning the
●For put option, dividend is high the underlying;
put value increases as Put options
gets more expensive due to the fact
that stock price always drop by the
dividend amount after ex-dividend
date 23
 3 Understanding option Greeks for various trading strategies
(volatility & Directional Spreads)

Directional strategy
A directional strategy is any trading or investment strategy that
●

entails taking a net long or short position in a market. It is betting

on the direction the overall market is going to move in.
A trader who is net long will benefit from a rise in the market.
●

One who is net short will benefit from a decline.

●

●Most long-term investors engage in the simple directional strategy

of holding a long portfolio of stocks and/or bonds.
Directional strategies are the opposite of market neutral strategies.
●

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 3 Understanding option Greeks for various trading strategies
(volatility & Directional Spreads)

A long/short directional strategy is one of opportunistically

●

having a net long or net short exposure to the market based upon
a short-term market view.
●As with the other strategies, this one seeks to add value through
selecting which stocks to go long or short, but it also seeks to add
value by deciding when to go net long or net short the market.
●The strategy should not be confused with a market neutral
strategy that combines long and short positions to achieve
zero net market exposure

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 3 Understanding option Greeks for various trading strategies
(volatility & Directional Spreads)

Volatility strategies.
●

●There are numerous strategies available for taking advantage of

increases or decreases in volatility.
●These strategies are called non-directional strategies or volatility
strategies. They are delta neutral strategies.
●Volatility is subject to the forces of supply and demand. Implied
volatility will tend to rise during periods when demand from options
buyers is strongest and will fall when demand is weakest.
The key for all options trader is to buy volatility when it is
●

perceived to be low and to sell volatility when it is perceived to be

high.

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 3 Understanding option Greeks for various trading strategies
(volatility & Directional Spreads)

●If a rise in implied ●If a fall in implied

volatility is expected volatility is expected

● Long straddle ● Short straddle

● Long strangle ● Short strangle
● Short butterfly ● Long butterfly

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 4 Delta /Dynamic Hedging

Dynamic hedging is a technique that is widely used

●

by derivatives dealers to hedge gamma or vega

exposures.(market movement and volatility)
●Because it involves adjusting a hedge as the
underlier/underlying moves—often several times a day—
it is “dynamic.”
Traded instruments or positions can generally be broken
●

down into two types:

● linear, and
● non-linear.
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 4 Delta /Dynamic Hedging

Linear instruments- The former includes spot positions, forward

●

positions and futures.

●Their payoffs or market values are either linear or almost linear
functions of their underliers.
Non-linear instruments include vanilla options, exotic derivatives
●

and bonds with embedded options

●Derivatives dealers transact in both linear and non-linear
instruments with clients.
●They tend to prefer to transact in non-linear instruments because
these are more difficult for clients to price, which means they can
make larger profits on those transactions.

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 4 Delta /Dynamic Hedging

●Clients tend to want to go long or short linear instruments with about equal
frequency.
●The same is not true of options or other non-linear instruments. Clients of
derivatives dealers routinely want to buy a call, buy a put, buy a cap, or buy
some exotic derivative.
●Rarely does a client call a derivatives dealer and ask to sell an option. After
selling to multiple clients, dealers are left holding large short options positions.
To hedge those positions, they would like to purchase offsetting long options,
●

but there is no one to buy these from.

●It makes little sense to buy them from other derivatives dealers, who are in the
same boat with their own large short options positions.

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 4 Delta / Dynamic Hedging
The solution is to dynamically hedge the short options positions.
●

●Dynamic hedging is delta hedging of a non-linear position using

linear instruments like spot positions, futures or forwards.
The deltas of the non-linear position and linear hedge position
●

offset, yielding a zero delta overall.

However, as the underlier’s value moves up or down, the delta
●

of the non-linear position changes while that of the linear hedge

does not.
●The deltas no longer offset, so the linear hedge has to be
adjusted (increased or decreased) to restore the delta hedge.
This continual adjusting of the linear position to maintain a
●

delta hedge is called dynamic hedging.

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 5 Beta of an option in CAPM
A measure of the volatility, or systematic risk, of a security or a portfolio
in comparison to the market as a whole.
Beta is used in the capital asset pricing model (CAPM), a model that
calculates the expected return of an asset based on its beta and
expected market returns.
A beta of 1 indicates that the security's price will move with the market.
A beta of less than 1 means that the security will be less volatile than the
market.
A beta of greater than 1 indicates that the security's price will be more
volatile than the market.
For example, if a stock's beta is 1.2, it's theoretically 20% more volatile
than the market. 32
 Risk and return
Many utilities stocks have a beta of less than 1.

Conversely, most high-tech, Nasdaq-based stocks have a beta of greater than 1, offering
the possibility of a higher rate of return, but also posing more risk.

Beta is a measure of how a stock’s volatility changes in relation to the overall market. An option's
beta is the covariance of the option's return with the market return divided by the variance of
the market return.

An option’s beta can be computed using the concept of elasticity. In other words, the option's
possible returns are related to the underlying's possible returns.

This brings to mind the capital asset pricing model (CAPM): if asset prices follow geometric
Brownian motions, the continuous-time CAPM holds.

As such, the expected return on a given asset, g, will satisfy the intertemporal CAPM equation:

CAPM Return
33
 Risk and return
●where rf is the risk-free rate, rm is the expected
return on the market portfolio, and βS is the beta
of the asset.
●Since the CAPM applies to all risky assets, it
also applies to options.
● The expected rate of return of a call option
written on the asset may be determined by first
figuring out its beta.
●The beta of a call is given by Black and Scholes
(1973): 34
 Risk and return
● While the beta of a put is:

● Put Beta
The expected rate of return of a call option on the
●

asset may be expressed as:

● Call Return
In this sense, the expected return on a beta
●

neutral option strategy should be equal to the risk-35

 Swaps

A swap is a derivative in which two counter parties exchange cash

flows of one party's financial instrument for those of the other party's
financial instrument.

The benefits in question depend on the type of financial instruments

involved.

For example, in the case of a swap involving two bonds, the

benefits in question can be the periodic interest (coupon) payments
associated with such bonds.

Specifically, two counter parties agree to exchange one stream of

cash flows against another stream.

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 A Currency Swaps

A swap that involves the exchange of principal and interest in one

currency for the same in another currency.
● It is considered to be a foreign exchange transaction and is not required

by law to be shown on a company's balance sheet.

●For example, suppose a U.S.-based bank needs to acquire British pounds

and a British bank needs to acquire U.S. Dollars.

● These two banks could arrange to swap currencies by establishing an

interest rate, an agreed upon amount and a common maturity date for the
exchange.
●Currency swap maturities are negotiable for at least 10 years, making them

a very flexible method of foreign exchange. 37

 B Interest Rate Swaps

●A popular and highly liquid financial derivative instrument in

which two parties agree to exchange interest rate cash flows,
based on a specified notional amount from a fixed rate to a
floating rate (or vice versa) or from one floating rate to another.
●Interest rate swaps are commonly used for both hedging and

speculating.
●The most common type of interest rate swap is one in which

Party A agrees to make payments to Party B based on a fixed

interest rate, and Party B agrees to make payments to Party A
based on a floating interest rate.
●The floating rate is tied to a reference rate (in almost all cases,

the London Interbank Offered Rate, or LIBOR).

38
 Interest Rate Swaps
1 Assume that Channel Bank (A) owns a $1,000,000 investment that pays
LIBOR + 1% every month. As LIBOR goes up and down, the payment
received changes.

2 Now assume that Soreal International (B) owns a $1,000,000 investment

that pays 1.5% every month. The payment she receives never changes.

A bank decides that they would rather lock in a constant payment and B
decides that she'd rather take a chance on receiving higher payments.
They agree to enter into an interest rate swap contract.

Under the terms of their contract, A agrees to pay B LIBOR + 1% per month
on a $1,000,000 principal amount (called the "notional principal" or "notional am

B agrees to pay A 1.5% per month on the $1,000,000 notional amount.

39
 Forward Rate Agreement
FRA is an agreement between two parties who agree on a fixed rate of interest
to be paid/received on a fixed date in the future.

The interest exchange is based on a notional principal amount for a term of

no greater than six months.

FRAs are used to assist companies manage interest rates exposures.

•

FRAs are over-the counter derivatives.

•

•FRAs can be used by investors who have a desire or need to alter their
• interest rate or cash flow profile to suit their particular needs.

• FRAs are used by investors looking to protect themselves from, or take

•advantage of, future interest rate movements.

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 Forward Rate Agreement vs SWAP

They are identical - except for the fact that FRA has 1 settlement period
whereas Swaps have multiple settlement periods.

FRAs are fixed in advance, paid in advance, while swaps are fixed in
advance, paid in arrears.

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 Warrants
A warrant is like an option. It gives the holder the right but not the obligation
to buy an underlying security at a certain price, quantity and future time.

It is unlike an option in that a warrant is issued by a company, whereas

an option is an instrument of the stock exchange.

A derivative security that gives the holder the right to purchase securities
(usually equity) from the issuer at a specific price within a certain time frame.
Warrants are often included in a new debt issue as a "sweetener" to entice
investors.

The main difference between warrants and call options is that warrants are
issued and guaranteed by the company, whereas options are exchange
instruments and are not issued by the company.

Also, the lifetime of a warrant is often measured in years, while the 42

lifetime of a typical option is measured in months.
 Warrants

Types of Warrants

There are two different types of warrants: a call warrant and a put warran

A call warrant represents a specific number of shares that can be

purchased from the issuer at a specific price, on or before a certain date.

A put warrant represents a certain amount of equity that can be

sold back to the issuer at a specified price, on or before a stated date

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 Caps
An interest rate cap is an agreement between two parties
providing the purchaser an interest rate ceiling or 'cap' on
interest payments on floating rate debts.

The rate cap itself provides a periodic payment

This financial instrument is primarily used by issuers of floating rate

debts in situations where short term interest rates are expected to incre

Rate caps can be viewed as insurance, ensuring that the maximum

borrowing rate never exceeds the specified cap level. Purchaser
pays the financial institution a premium.

Caps are purchased for a premium and typically have expirations

between 1 and 7 years.
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 Floors

A Floor is the combination of owning an asset and owning a

put option on that asset.

A Floor provides insurance against a falling asset price.

Interest rate floor is a derivative contract in which the buyer receives

payments at the end of each period in which the interest rate is
below the agreed strike price.

Caps and floors can be used to hedge against interest rate fluctuations

45