A.

Delta
● Delta of a portfolio is the partial derivative of a portfolio with respect to the price of
the underlying asset (gold in this case)
● Suppose that a $0.1 increase in the price of gold leads to the gold portfolio decreasing
in value by $100
● The delta of the portfolio is -1000
● The portfolio could be hedged against short-term changes in the price of gold by
buying 1000 ounces of gold. This is known as making the portfolio delta neutral.
B. Linear vs Nonlinear Products
● When the price of a product is linearly dependent on the price of an underlying asset a
"hedge and forget" strategy can be used (like the gold portfolio above).
● Non-linear products require the hedge to be rebalanced to preserve delta neutrality
In order to hedge its risk and lock in a $60,000 profit, the bank can take a short position in the
underlying stock or a related derivative. Since the bank has sold a call option, it is exposed to
the risk of the stock price increasing beyond the strike price. By taking a short position, the
bank can offset any potential losses if the stock price rises.
For example, if the bank takes a short position in the underlying stock, it would sell 100,000
shares of the stock. If the stock price increases, the bank would profit from the decrease in the
stock's value, which would offset any losses from the call option.
Alternatively, the bank could take a short position in a related derivative, such as a put option
or a futures contract. These derivatives also move in the opposite direction of the call option,
providing a hedge against potential losses.
By implementing a hedging strategy, the bank can protect itself from potential losses and
lock in a profit of $60,000.

C. Vega
● Vega (V) is the rate of change of the value of a derivatives portfolio with respect to
volatility
● Like gamma, vega tends to be greatest for options that are close to the money
 D. Theta
● Theta of a derivative (or portfolio of derivatives) is the rate of change of the value
with respect to the passage of time
● The theta of a call or put is usually negative. This means that, if time passes with the
price of the underlying asset and its volatility remaining the same, the value of the
option declines.
E. Rho
● Rho is the partial derivative with respect to a parallel shift in all interest rates in a
particular country

Example: a) How to make the portfolio gamma neutral?

Can use either Option to make Gamma neutral. E.g., if we use Option 1:

So w1 = 5000/0.5 = 10000
We need to include 10000 Option 1 to make Gamma neutral.
b) How to make the portfolio gamma and vega neutral?

Solve this system, we have w1 = 400, and w2 = 6,000

We need to include 400 Option 1 and 6,000 Option 2 to make the portfolio gamma and vega
neutral
c) How to make the portfolio delta neutral again after (b)?
The Delta of the portfolio after including 400 Option 1 and 6,000 Option 2 is:
400 × 0.6 + 6,000 × 0.5 = 3,240
Therefore, 3,240 units of the underlying asset need to be sold to maintain the delta neutrality
Example 8.3
Consider again the European call option in Section 8.1. The stock price is $49, the strike
price is $50, the risk-free rate is 5%, the stock price volatility is 20%, and the time to exercise
is 20 weeks or 20/52 year. Table 8.4 shows delta, gamma, vega, theta, and rho for the option
(i.e., for a long position in oneoption) and for a short position in 100,000 options, which was
the position considered in Tables 8.2 and 8.3.
Here are some examples ot now these numbers can be interpreted:
1. When there is an increase of $0.1 in the stock price with no other changes, the option price
increases by about 0.522 × 0.1 or $0.0522. The value of a short position in 100,000 options
decreases by $5,220.
2. When there is an increase of $0.1 in the stock price with no other changes, the delta of the
option increases by about 0.066 x 0.1 or 0.0066. The delta of a short position in 100,000
options decreases by 660.
3. When there is an increase in volatility of 0.5% from 20% to 20.5% with no other changes,
the option price increases by about 0.121 × 0.5 or $0.0605. The value of a short position in
100,000 options decreases by $6,050.
4. When one day goes by with no changes to the stock price or its volatility, the option price
decreases by about $0.012. The value of a short position in 100,000 options increases by
$1,200.
5. When interest rates increase by 1% (or 100 basis points) with no other changes, the option
price increases by $0.089. The value of a short position in 100,000 options decreases by
$8,900.
**What is the difference between GARCH and EWMA for estimating volatility from
historical data.

F. EWMA

The EWMA approach is found attractive due to the fact that we store relatively little data. At
any given time, only the current estimate of the variance and the most recent observation on
the value of the market variable need to be remembered. The EWMA approach is designed to
track changes in the volatility.

When the EWMA model is used, the estimation procedure is relatively simple compare to
GARCH.

G. GARCH

This form of the model is frequently used for the purpose of estimating the parameters.

The GARCH model is similar to EWMA model except that, in addition to the assigning
weights that decline exponentially to past u2 , it also assigns some weight to long-run average
volatility.
 Bài giải ví dụ

8.1 The delta of a derivatives portfolio dependent on an index is -2,100. The index is currently
1,000. Estimate what happens to the value of the portfolio when the index increases to 1,005.
Delta = deltaP/deltaS = -2100
Value of portfolio is a function of an index
Slope = rise / sun = -2100
deltaS = 1005-1000= 5
deltaP = Delta x deltaS
=> deltaP = -2100 x 5 = -10500
8.2 The vega of a derivatives portfolio dependent on the dollar-sterling exchange rate is 200 (per
%). Estimate the effect on the portfolio of an increase in the volatility of the exchange rate from
12% to 14%.
Vega of the portfolio is $200 per % change in exchange rate .
As the exchange rate is increasing by 2% (14% from 12% ), the derivative portfolio price will
increase by 2*$200 =$ 400.
8.3 The gamma of a delta-neutral portfolio is 30. Estimate what happens to the value of the
portfolio when the price of the underlying asset (a) suddenly increases by $2 and (b) suddenly
decreases by $2.
Gamma is a second order derivative so its impact will be : Gamma×(Change in price)^2/2 A.30×(2)^2
/ 2 =60 increase.
B. 30×(-2)^2 /2 = 60 increase
8.4 What does it mean to assert that the delta of a call option is 0.7? How can a short position in
1,000 options be made delta neutral when the delta of a long position in each option is 0.7?
Delta neutral means that you hedge your risk. If you were short 1,000 optioins with a delta of
0.7,
then in order to be delta neutral, you need to buy the underlying asset = 0.7 x 1,000 = 700
units.
8.5 What does it mean to assert that the theta of an option position is-100 per day? If a trader
feels that neither a stock price nor its implied volatility will change, what type of option position
is appropriate?
A theta of -0.1 means that if delta(t) units of time pass with no change in either the stock
price or its volatility, the value of the option declines by 0.1delta(t).
A trader who feels that neither the stock price nor its implied volatility will change should
write an option with as high a negative theta as possible. Relatively short-life at-the-money
options have the most negative thetas.
8.6 What is meant by the gamma of an option position? What are the risks in the situation
where the gamma of a position is large and negative and the delta is zero?
The gamma of an option position is the rate of change of the delta of the position with respect to the
asset price. For example, a gamma of 0.1 would indicate that when the asset price increases by a
certain small amount delta increases by 0.1 of this amount.
When the gamma of an option writer's position is large and negative and the delta is zero, the option
writer will lose significant amounts of money if there is a large movement (either an increase or a
decrease) in the asset price.
8.7 "The procedure for creating an option position synthetically is the reverse of the procedure
for hedging the option position." Explain this statement.
To hedge an option position it is necessary to create the opposite option position synthetically.
For example, to hedge a long position in a put it is necessary to create a short position in a put
synthetically. It follows that the procedure for creating an option position synthetically is the reverse
of the procedure for hedging the option position.
8.8 A company uses delta hedging to hedge a portfolio of long positions in put and call options
on a currency. Which of the following would lead to the most favorable result?
(a) A virtually constant spot rate
(b) Wild movements in the spot rate
How does your answer change if the portfolio contains short option positions?
The answer is B. Wild movements in the spot rate.
Long position may be either put or call having a positive gamma. When gamma is positive, there is
gain from large change in stock price and loses from small change in stock price. Hence option B
would lead to favourable result.
Short option positions have negative gamma. Here there is gain from small change in stock price and
loses with large change in stock price. So A. Virtually constant rate would lead to favourable result
8.9 A bank's position in options on the dollar-euro exchange rate has a delta of 30,000 and a
gamma of -80,000. Explain how these numbers can be interpreted. The exchange rate (dollars
per euro) is 0.90. What position would you take to make the position delta neutral? After a
short period of time, the exchange rate moves to 0.93. Estimate the new delta. What additional
trade is necessary to keep the position delta neutral? Assuming the bank did set up a delta-
neutral position originally, has it gained or lost money from the exchange-rate movement?
- The delta indicates that when the value of the euro exchange rate increases by $0.01, the
value of the bank's position increases by 0.01×30,000 = $300.
- The gamma indicates that when the euro exchange rate increases by $0.01 the delta of the
portfolio decreases by 0.01-80,000 = 800 .
- For delta neutrality 30,000 euros should be shorted. When the exchange rate moves up to
0.93, we expect the delta of the portfolio to decrease by (0.93-0.90) ×80,000 = 2, 400 so that
it becomes 27,600. To maintain delta neutrality, it is therefore necessary for the bank to
unwind its short position 2,400 euros so that a net 27,600 have been shorted.
- when a portfolio is delta neutral and has a negative gamma, a loss is experienced when there
is a large movement in the underlying asset price. We can conclude that the bank is likely to
have lost money.
8.10 "Static options replication assumes that the volatility of the underlying asset will be
constant." Explain this statement.
When used in the way described in the text, it does assume volatility is constraint. In theory, we could
implement a static options replication strategy where there are 3 dimensions time, the stock price, and
volatility. Prices are then matched on a surface in the 3-dimensions space.
8.11 Suppose that a trader using the static options replication technique wants to match the
value of a portfolio of exotic derivatives with the value of a portfolio of regular options at 10
points on a boundary. How many regular options are likely to be needed? Explain your answer.
10 regular options are likely to be needed. This is because there are 10 equations to be satisfied. One
for each point on the boundary.
8.12 Why is an Asian option easier to hedge than a regular option?
The payoff from an Asian option becomes more ceotain with the passage of time. As a result, the
amount of undertainly that needs to be hedged decrease with the passage of time.
8.13 Explain why there are economies of scale in hedging options.
Economies of scale are cost advantagescompanies experience when hedging becomes efficient, as
costs can be spread over a larger amount of options.
There is large fixed costs in hedging options if we could rise the size if hedging then it becomes less
costly, it means that the benefits of hedging must exceed the costs.Economies of scale allow larger
firms to hedge at lower costs.
8.14 Consider a six-month American put option on a foreign currency when the exchange rate
(domestic currency per foreign currency) is 0.75, the strike price is 0.74, the domestic risk-free
rate is 5%, the foreign risk-free rate is 3%, and the exchange-rate volatility is 14% per annum.
Use the RMFI software (binomial tree with 100 steps) to calculate the price, delta, gamma, vega,
theta, and rho of the option. Verify that delta is correct by changing the exchange rate to 0.751
and recomputing the option price.
There are 0.0217, -0.396, 5.145, 0.00203, -0.0000626 and -0.00119. Delta predicts that the option
price should decrease by approximately 0.000396 when the exchange rate increase by 0.001. This is
what we find when the ex rate is increased to 0.751. The option price decrease 0.00213.
8.15 The gamma and vega of a delta-neutral portfolio are 50 and 25, respectively, where the
vega is "per %." Estimate what happens to the value of the portfolio when thereis a shock to the
market causing the underlying asset price to decrease by $3 and its volatility to increase by 4%.
With the notation of the text, the increase in the value of the portfolio is 0.5× gamma×(deltaS)² +vega
x delta(o)
This is 0.5 x 50 x 3² + 25 × 4=325
The result should be an increase in the value of the portfolio of $325.
8.16 Consider a one-year European call option on a stock when the stock price is $30, the strike
price is $30, the risk-free rate is 5%, and the volatility is 25% per annum. Use the RMFI
software to calculate the price, delta, gamma, vega, theta, and rho of the option. Verify that
delta is correct by changing the stock price to $30.1 and recomputing the option price. Verify
that gamma is correct by recomputing the delta for the situation where the stock price is $30.1.
Carry out similar calculations to verify that vega, theta, and rho are correct.
The price, delta, gamma, vega, theta, and rho of the option are 3.7008, 0.6274, 0.050, 0.1135, -
0.00596, and 0.1512. When the stock price increases to 30.1, the option price increases to
3.7638.
The change in the option price is 3.7638- 3.7008 = 0.0630.
Delta predicts a change in the option price of 0.6274 × 0.1 = 0.0627 which is very close.
When the stock price increases to 30.1, delta increases to 0.6324. The size of the increase in delta is
0.6324 – 0.6274=0.005.
Gamma predicts an increase of 0.050 × 0.1 = 0.005 which is (to three decimal places) the same.
When the volatility increases from 25% to 26%, the option price increases by 0.1136 from 3.7008 to
3.8144. This is consistent with the vega value of 0.1135.
When the time to maturity is changed from 1 to 1–1/365 the option price reduces by 0.006 from
3.7008 to 3.6948. This is consistent with a theta of–0.00596.
Finally, when the interest rate increases from 5% to 6%, the value of the option increases by 0.1527
from 3.7008 to 3.8535. This is consistent with a rho of 0.1512.
8.17 A financial institution has the following portfolio of over-the-counter options on pounds
sterling:
A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
(a) What position in the traded option and in pounds sterling would make the portfolio both
gamma neutral and delta neutral?
(b) What position in the traded option and in pounds sterling would make the portfolio both
vega neutral and delta neutral?
The delta of the portfolio is
-1, 000 x 0.50 – 500 × 0.80–2,000 × (−0.40) – 500 × 0.70=-450
The gamma of the portfolio is
-1, 000 × 2.2 – 500 × 0.6 - 2.000 x 1.3 - 500 x 1.8 = -6000
The vega of the portfolio is
-1, 000 x 1.8 – 500 × 0.2 - 2,000 × 0.7 – 500 × 1.4=-4,000
(a) A long position in 4,000 traded options will give a gamma-neutral portfolio since the long position
has a gamma of 4, 000 × 1.5 = +6,000. The delta of the whole portfolio (including
traded options) is then: 4, 000 × 0.6 – 450 1,950
Hence, in addition to the 4,000 traded options, a short position in £1,950 is necessary so that the
portfolio is both gamma and delta neutral.
(b) A long position in 5,000 traded options will give a vega-neutral portfolio since the long position
has a vega of 5, 000 × 0.8 =+4,000. The delta of the whole portfolio (including traded options) is then
5, 000 × 0.6 – 450 =2, 550
Hence, in addition to the 5,000 traded options, a short position in £2,550 is necessary so that the
portfolio is both vega and delta neutral.
8.18 Consider again the situation in Problem 8.17. Suppose that a second traded option, with a
delta of 0.1, a gamma of 0.5, and a vega of 0.6, is available. How could the portfolio be made
delta, gamma, and vega neutral?
Let wi be the position in the first traded option and w2 be the position in the second traded option. We
require:
6, 000 = 1.5w+0.5w2
4, 000 = 0.8w +0.6w2
The solution to these equations can easily be seen to be wi = 3,200, w2 = 2,400. The whole portfolio
then has a delta of
-450+3,200 × 0.6+2,400 × 0.1 = 1,710
Therefore the portfolio can be made delta, gamma and vega neutral by taking a long position in 3,200
of the first traded option, a long position in 2,400 of the second traded option and a short position in
£1,710.
8.19 Check the first three rows of Table 8.2 using the RMFI software. Calculate the gamma and
theta of the position during the first three weeks, and the change in the value of the position
(before the end-of-week rebalancing) during each of these weeks. Check whether equation (8.2)
is approximately satisfied. (Note: The software produces a value of theta per calendar day. The
theta in equation (8.2) is per year.)
Consider the first week. The portfolio consists of a short position in 100,000 options and a long
position in 52,200 shares.
The value of the option changes from $240,053 at the beginning of the week to $188,760 at the end of
the week for a gain of $51,293
The value of the shares change from 52,200 × 49 =$2,557, 800 to 52,200 × 48.12 = $2,511,864 for a
loss of $45,936.
The net gain is 51,293 – 45,936 = $5,357.
The gamma and theta (per year) of the portfolio are -6,554.4 and 430,533 so that equation (8.2)
predicts the gain as
430,533 x1/52 + 0.5 × 6,554.4 × (48.12 – 49)^2=5,742
The results for all 20 weeks are shown in the following table.