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Example 1
A bank has sold for $300,000 a European call option on 100,000 shares of a non-
dividend paying stock
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Example 2
A bank has sold for $300,000 a European call option on 100,000 shares of a non-
dividend paying stock
S0 = 49, K = 50, r = 5%, σ = 20%, T = 20 weeks, µ = 13%
Note:
(S) = 1 & (S) = 0 & (S) = 0
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The Greeks II
f: The derivative
Change in option value = Δ * Change in S
Change in option value = Θ * Change in time
Change of Δ = Γ * Change in S
Change in option price = [Δ * Change in S] + 0.5 * Γ * [Change in S]2
Change in option price = * Change in σ of S (Vega!)
Change in option price = * Change in r
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Example 3
Suppose a stock is currently trading at 100. An at-the-money call with a maturity of
three months is priced at 5.598 and has a Vega= 19.685
A. If the volatility increases by 1%, what is the predicted new value of the call?
B. What if volatility fell by 2%?
Recall
Change in option price = * Change in σ
A. dσ = +0.01: Call value will change by (19.685)(+0.01) = +0.197. Thus, the
predicted new call value is 5.598 + 0.197 = 5.795.
B. dσ = -0.02: Call value will change by (19.685)(-0.02) = -0.394. Thus, the
predicted new call value is 5.598 – 0.394 = 5.204
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Example 4
S0 = $100, c = $10
A. The value of the portfolio remains the same
Trader has sold 2000 call options
no matter how the price changes (small
The Δ of the option is given below. changes)
A. What is meant by a delta-neutral portfolio? B. Δ: # of units of stock to hold for each call
B. What does delta refer to if the trader had sold 1 shorted to create a riskless portfolio
call?
10
Slope = D =0.6
St
100
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Example 5
S0 = $100, c = $10 0.6*2000
= 1200
Trader can hedge by buying 1200 shares
Trader has sold 2000 call options
The Δ of the option is given below.
Π = -2000c + 1200S
How can he construct a delta neutral portfolio?
Validate by considering St ↑ 100.01 & St ↓ 99.99 St ↑ 100.01 Trader loses -2000*0.6*0.01 on
short position and gains 1200*0.01 on long
position
c
St ↓ 99.99 Trader gains 2000*0.6*0.01 on
short position and loses 1200*0.01 on long
position
Π is Delta Neutral
10
Slope = D = 0.6
St Note: Δ of Underlying = 1
100
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Example 6
S0 = $100, c = $10 Π = -2000c + 1200S
Trader has sold 2000 call options
The Δ of the option is given below. Differentiate wrt to S, we get
Π = -2000c + 1200S is the delta neutral portfolio.
Validate.
= -2000*0.6 + 1200 * 1 = 0
10
Slope = D = 0.6
St
100
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Delta Neutral Hedge
• Gain/loss on the option position is offset by loss/gain on stock position
• Delta changes as stock price changes and time passes
• Hedge position must therefore be rebalanced
• Delta of a Portfolio:
• Interpretation of Δ:
• Δ < 0: Buy the underlying asset
• Δ > 0: Short the underlying asset
Example: S0 = $100, c = 10 & Δ = 0.6. Trader has sold 2000 call options
• = -2000 c
• = -1200
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Delta of European Options
The delta of a European call on a non-dividend paying stock: N(d1)
The delta of a European put on a non-dividend paying stock: N(d1) – 1
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Example 7
Trader1 has sold 100 call option & Trader2 has bought 100 put option
Currently S0 = 40, K = 45, r = 3%pa, σ = 40% pa, T = 1/3
c = 2.00, p = 6.00
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Example 8
Suppose a financial institution has the following positions:
1. A long position in 100,000 call options with K = 55, T = 3m, Δ = 0.533
2. A short position in 200,000 call options with K = 56, T = 5m, Δ = 0.468
3. A short position in 50,000 put options with K = 56, T = 2m, Δ = -0.508
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Gamma
is the rate of change of Δ with respect to the price of the underlying
Addresses hedging Errors due to Curvature
C''
C'
C
St
S S'
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Example 9
is the rate of change of Δ with respect to the price of the underlying
2. Given a choice between 2 portfolios A and B with (A) < (B), which do you prefer?
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Delta & Gamma Neutral
is a portfolio of options on the same asset.
It is delta neutral and has a gamma of -3000. We want to also make it neutral.
There is traded derivative f on the same asset with = 0.62 and = 1.50
Consider * = + 2000 f
(*) = -3000 + 2000*1.50 = 0
However (*) = 0 + 2000*0.62 = 1240
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Vega
Vega (n) is the rate of change of the value of a derivatives portfolio with
respect to volatility
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Managing Delta, Gamma, & Vega
Delta
can be changed by taking a position in the underlying asset
To adjust gamma and vega it is necessary to take a position in another derivative
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Example 10
Delta Gamma Vega
Portfolio Π 0 −5000 −8000
Option 1 0.6 0.5 2.0
Π* = Π + w1 Option1 + w2 S
Let
Δ(Π*) = 0 and (Π*) = 0 gives:
0 + 0.6w1 + w2 = 0 & -5000 + 0.5 w1 = 0
w1 = 10,000 and w2 = -6000
We require a long position of 10,000 Option 1 and a short position of 6000 in the
asset to make the portfolio delta and gamma neutral
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Example 11
Delta Gamma Vega
Portfolio 0 −5000 −8000
Option 1 0.6 0.5 2.0
Π* = Π + w1 Option1 + w2 S
Let
Δ(Π*) = 0 and n(Π*) = 0 gives:
0 + 0.6w1 + w2 = 0 & -8000 + 2w1 = 0
w1 = 4,000 and w2 = -2400
We require a long position of 4,000 Option 1 and a short position of 2,400 in the
asset to make the portfolio delta and vega neutral
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Example 12
Delta Gamma Vega
Portfolio 0 −5000 −8000
Option 1 0.6 0.5 2.0
Option 2 0.5 0.8 1.2
What position in option 1, option 2, and the asset will make the portfolio delta, gamma, and vega
neutral?
Π* = Π + w1 Option1 + w2 Option2 + w3S
Let
Δ(Π*) = 0, (Π*) = 0 and n(Π*) = 0 gives:
0 + 0.6w1 + 0.5w2 + w3 = 0, -5000 + 0.5w1 + 0.8w2 = 0 & -8000 + 2w1 + 1.2
w2 = 0
w1 = 400 and w2 = 6000, w3 = -3240
We require long positions of 400 and 6000 in option 1 and option 2 and a short
position of 3240 in the asset make the portfolio delta, gamma and vega neutral
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Example 13
Suppose
(Π), where Π is a delta-neutral portfolio of options, on an asset is -10,000
Suppose in an infinitesimal time, there is a change of +10 in the asset. What is the
change in the portfolio value?
In an infinitesimal time there is a change of +10 in the asset
There is a change of 0.5*(-10,000)*100 = -500,000
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Example 14
A stock has a volatility of 20% and the call option has a vega of 100. By how much
will the call value change if volatility rises to 22%? Assuming the options are
European, what about the corresponding put?
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Hedging in Practice
Traders usually ensure that their portfolios are delta-neutral at least once a day
Whenever the opportunity arises, they improve gamma and vega
There are economies of scale
– As portfolio becomes larger hedging becomes less expensive per option in the
portfolio
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