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P1.T4. Valuation & Risk Models
Chapter 16. Option Sensitivity Measures: The

“Greeks”
Bionic Turtle FRM Practice Questions

By David Harper, CFA FRM CIPM
www.bionicturtle.com
Chapter 16. Option Sensitivity Measures: The “Greeks”

P1.T4.817. OPTION DELTA ....................................................................................................... 3
P1.T4.818. FUTURES DELTA AND DYNAMIC DELTA HEDGING ....................................................... 6
P1.T4.819. THETA, GAMMA AND VEGA FOR OPTION POSITIONS ................................................... 9
P1.T4.820. DELTA- AND GAMMA-NEUTRAL POSITION; AND THE RELATIONSHIP BETWEEN DELTA,
THETA, AND GAMMA.................................................................................................................11
P1.T4.821. DELTA HEDGING, SCENARIO ANALYSIS AND PORTFOLIO INSURANCE ..........................15
P1.T4.400. OPTION DELTA ......................................................................................................19
P1.T4.401. OPTION GAMMA ....................................................................................................22
P1.T4.402. OPTION VEGA .......................................................................................................24
P1.T4.403. OPTION THETA ......................................................................................................26
P1.T4.404. NEUTRALIZING OPTION POSITION GREEKS ..............................................................28
P1.T4.6. OPTION DELTA ..........................................................................................................30
P1.T4.7. DYNAMIC DELTA HEDGING .........................................................................................33
P1.T4.8. OPTION GREEKS.......................................................................................................37
P1.T4.9. GAMMA-NEUTRAL OPTION POSITIONS .........................................................................39
Hull: Options, Futures & Other Derivatives – Chapter 19 Q&A

PROBLEM 19.1. ......................................................................................................................42
PROBLEM 19.2. ......................................................................................................................42
PROBLEM 19.3. ......................................................................................................................43
PROBLEM 19.4. ......................................................................................................................44
PROBLEM 19.5. ......................................................................................................................44
PROBLEM 19.6. ......................................................................................................................44
PROBLEM 19.7. ......................................................................................................................44
PROBLEM 19.8. ......................................................................................................................45
PROBLEM 19.9. ......................................................................................................................45
PROBLEM 19.10. ....................................................................................................................46
PROBLEM 19.11. ....................................................................................................................46
PROBLEM 19.12. ....................................................................................................................47
PROBLEM 19.13. ....................................................................................................................47
PROBLEM 19.14. ....................................................................................................................47
PROBLEM 19.15. ....................................................................................................................49
PROBLEM 19.16. ....................................................................................................................50
PROBLEM 19.17. ....................................................................................................................52
PROBLEM 19.18. ....................................................................................................................54
PROBLEM 19.19 .....................................................................................................................55
PROBLEM 19.20. ....................................................................................................................56
PROBLEM 19.21. ....................................................................................................................57
PROBLEM 19.22. ....................................................................................................................57
PROBLEM 19.23. ....................................................................................................................58
PROBLEM 19.24. ....................................................................................................................59
PROBLEM 19.25. ....................................................................................................................60
PROBLEM 19.26. ....................................................................................................................61
PROBLEM 19.27. ....................................................................................................................62
PROBLEM 19.28. ....................................................................................................................63
PROBLEM 19.29. ....................................................................................................................65
PROBLEM 19.30. (EXCEL FILE).................................................................................................66
2
Chapter 16. Option Sensitivity Measures: The “Greeks”

P1.T4.817. Option delta
P1.T4.818. Futures delta and dynamic delta hedging
P1.T4.819. Theta, gamma and vega for option positions
P1.T4.820. Delta- and gamma-neutral position; and the relationship between delta, theta,
and gamma
P1.T4.821. Delta hedging, scenario analysis and portfolio insurance
P1.T4.401. Option gamma
P1.T4.402. Option vega
P1.T4.403. Option theta
P1.T4.404. Neutralizing option position Greeks
P1.T4.7. Dynamic delta hedging
P1.T4.8. Option Greeks
P1.T4.9. Gamma-neutral option positions
Hull’s Textbook Q&A

Learning objectives: Describe and assess the risks associated with naked and covered
option positions. Explain how naked and covered option positions generate a stop loss
trading strategy. Compute the delta of an option.
817.1. As a market maker, Toughgreen Financial has written (aka, taken a short position in) a
single contract for 100 call options on a non-dividend-paying stock whose volatility is 36.0% per
annum when the riskless rate is 3.0%. Their strike price is $100.00 but the options are
underwater because the current stock price is $90.00. The option term is six months. At the
current stock price, each option has a value of $5.88 and each option's percentage delta, Δ =
+0.410. From Toughgreen's perspective, if the stock price increases by +$3.00 to $93.00, which
is nearest to the impact on the position's value?
a) A loss of few dollars less than $8.00; ie, 100 * [$5.88 * ($3.00/$90.00) * 0.410] minus (-)
gamma adjustment
b) A loss of few dollars more than $8.00; ie, 100 * [$5.88 * ($3.00/$90.00) * 0.410] plus (+)
gamma adjustment
c) A loss of few dollars less than $123.00; ie, 100 * ($3.00 * 0.410) minus (-) gamma
adjustment
d) A loss of few dollars more than $123.00; ie, 100 * ($3.00 * 0.410) plus (+) gamma
adjustment
3
817.2. A non-dividend-paying stock has a volatility, σ, equal to 35.0% and a current price of
$60.00 while the riskfree rate is 4.0%. Which is nearest to the percentage delta, Δ(p), of a six-
month put option with an exercise price of $75.00?
a) -2.2127
b) -0.7580
c) -0.2420
d) +0.2429
817.3. Greendex Financial LLC is a market maker who, at the request of its client, has written
out-of-the-money (OTM) call options on the stock of Industrial Automation, Inc. Greendex wrote
100 contracts, and the size of each contract is 100 options with nine month maturities. Because
S(0) = $20.00, K = $25.00, σ = 40.0%, Rf = 4.0% and T = 0.75 years, the percentage delta Δ(c)
of each call option is +0.350.
Greendex immediately seeks to neutralize its delta exposure (i.e., achieve a position delta equal
to zero) by trading put options on the same underlying stock, Industrial Automation, Inc.
Compared to the call options, these put options will have an identical strike price and maturity.
Which of the following trades is advisable to neutralize its delta, and after having neutralized
delta, what is the nature of Greendex's retained gamma exposure?
a) Write about 54 put option contracts (100 put options per contract) but Acme is exposed to
wild movements in the stock price
b) Write about 54 put option contracts (100 put options per contract) but Acme is exposed to a
virtually constant stock price
c) Write about 185 put option contracts (100 put options per contract) but Acme is exposed to
wild movements in the stock price
d) Write about 185 put option contracts (100 put options per contract) but Acme is exposed to
a virtually constant stock price
4
Answers:
817.1. D. True: A loss of few dollars more than $123.00; ie, 100 * ($3.00 * 0.410) plus (+)
gamma adjustment.
As a partial first derivative, delta is the rate of change of the option price with respect to the
price of the underlying asset (stock, in this case): Δ = ∂c/ ∂S. A percentage delta of 0.410
signifies the expectation of a linear change of $0.410 in the call option value for each $1.00
change in the stock price. However, this excludes the gamma adjustment: the actual price
increase in the call option is GREATER than the change estimated by the linear approximation.
Consequently, the short position (who writes the call) is exposed to a greater price drop.
Specifically, in this example (although the problem does NOT require calculating gamma!), the
percentage gamma is about 0.0170 such that the loss due to a +$3.00 stock price change is
$3.00*0.410 + 0.5*0.0170*$3.00^2 = $1.3065. Indeed, the actual option price increases from
$5.882 to $7.188, for an exact difference of $1.3060. In this way, the actual loss on the position
(of 100 options) is $130.60 while the delta-gamma estimate is $130.65
817.2. B. True, Δ(p) = -0.7580. The exact N(d1) is 0.24288 while lookup-based N(-0.70) is
0.2420 such that Δ(p) = N(d1) - 1 = 0.2420 - 1 = -0.7580, or exactly -0.75712. However, this
question can be answered without any calculations given that we should know the percentage
delta of a put is negative and lies between -1.0 and zero. Further, this put option is in-the-money
(ie., S < K) such that we expect the delta to be nearer to -1.0 than zero.
817.3. A. True: Write about 54 contracts (100 put options per contract) but Acme is
exposed to wild movements in the stock price
The initial position delta = (-100*100)*0.350 = -3,500 such that 3,500/(0.35 - 1.0) = 5,384.62 put
options will neutralize delta, or about 54 contracts. To neutralize the negative position delta, the
puts must contribute positive position delta which requires they short put positions.
After neutralizing delta, Greendex has a short gamma position because Greendex has written
calls and written puts. Consequently, Greendex is exposed to volatility. Specifically, the
exposure is to realized volatility that exceeds the implied volatility at the time of writing the
options; i.e., the price of the written options "embeds" the stock's implied volatility, by definition.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-817-option-delta-hull-

ch-19.20318/
5
P1.T4.818. Futures delta and dynamic delta hedging

Learning objectives: Describe delta hedging for an option, forward, and futures
contracts. Describe the dynamic aspects of delta hedging and distinguish between
dynamic hedging and hedge-and-forget strategy. Define the delta of a portfolio.
818.1. A market maker takes a short position in 1,000 European call options on copper futures.
The options mature in three months, and the futures contract underlying the option matures in
four months. The current four-month futures price is $3.30 per pound, the exercise price of the
options is $3.00, the risk-free interest rate is 4.0% per annum, and the volatility of silver futures
prices is 20.0% per annum. Which is nearest to the position delta? (note: this question is
inspired by Hull's EOC Question 19.10)
a) -833.0
b) -525.0
c) -314.0
d) +267.0
818.2. Goldgreen International is an investment bank who has written 100,000 call options with
a strike price of $50.00 on a stock whose volatility is 32.0% per annum while the risk-free rate is
3.0% per annum. The options initially have a maturity of 20 weeks, when the percentage delta is
0.5220 (see first row below). Because Goldgreen seeks to dynamically maintain delta neutrality,
the firm immediately purchases 52,000 shares. Consequently, the initial position delta is zero.
Although Goldgreen prefers the performance of continuous re-balancing, due to transaction
costs, it decides to re-balance once per week. The exhibit below simulates five weeks of stock
price changes (note: this is a variation on Hull's Table 19.3):
As shown, at the end of the fifth week, the stock price has dropped to $48.20. At this time, what
is the trade (i.e., number of shares purchased) that Goldgreen will execute?
a) Sell 3,375 shares
b) Sell 5,500 shares
c) Buy 2,190 shares
d) Buy 8,540 shares
6
818.3. Translab Financial is a broker-dealer who earlier today executed two sets of trades on
behalf of clients:
 Client #1 entered into 100 option contracts for a nine-month straddle on the stock of
ABC Corp at a strike price of $10.00 while the stock price is $9.00. Consequently,
Translab's position is a "top straddle" or "straddle write" where Translab writes the calls
and puts. The percentage delta of the out-of-the-money (OTM) calls is 0.470.
 Client #2 entered into 100 option contracts for a six-month bull spread on the stock of
XYZ Corp while the stock price is $19.00. Because (in the bull spread) the client buys
calls at the lower strike price of $18.00 and sells calls with a higher strike price of
$25.00, Translab as its counterparty effectively has a position in bear spread: Translab is
long the call option with the higher strike price and short the call option with the lower
strike price. The out-of-the-money calls (with an $25.00 strike price) have a percentage
delta of 0.20, and the in-the-money calls (with a $18.00 strike price) have a percentage
delta of 0.660.
All option contracts are for 100 options each. If Translab seeks to fully hedge (aka, neutralize)
its exposure with respect to the position delta created by these client-initiate trades, which of the
following two trades will achieve its goal?
a) Buy 250 shares of ABC Corp and Sell 1,750 shares of XYZ Corp
b) Buy 900 shares of ABC Corp and Sell 3,800 shares of XYZ Corp
c) Sell 600 shares of ABC Corp and Buy 4,600 shares of XYZ Corp
d) Sell 1,800 shares of ABC Corp and buy 1,330 shares of XYZ Corp
7
Answers:
818.1. A. -833.0
Position delta is given by the product of quantity and percentage delta: ΔP = Qty * %Δ. In this
case, we want the percentage delta of a call option on a copper futures contract. According to
Hull, the (percentage) delta of European futures call option is usually defined as the rate of
change of the option price with respect to the futures price (not the spot price) and is given
by exp(-rT)*N(d1) where d1 = ( ln[F(0)/K] + σ^2*T )/ [σ*sqrt(T)]. In this case:
 d1 = [LN(3.30/3.00) + (0.20^2/2)*0.25] / 0.20*sqrt(0.250) = 1.003102 or approximately

1.0. Note the maturity of the futures contract is not utilized.
Position Δ = 1,000 * N(d1)*exp(-rT) = 1,000*N(1)*exp(-0.040*.25) = -1,000 * 0.841345 * exp(-

0.040*.25) = -832.9; or with exact an exact N(d1) value, the answer is -833.715.
818.2. B. Sell 5,500 shares. The position delta has changed by (0.469 - 0.524) * 100,000 = -
5,000 such that 5,500 shares (with unit percentage delta each) should be sold.
818.3. C. Sell 600 shares of ABC Corp and Buy 4,600 shares of XYZ Corp
In regard to the top straddle, because Δ(p) = N(d1) - 1 = 0.470 - 1 = -0.530, Translab's position
delta = -10,000* 0.470 + (-10,000 * -0.530) = +600. Consequently, selling 600 shares will
neutralize delta. In regard to the bear spread, Translab's position delta = +10,000 * 0.20 + (-
10,000 * 0.66) = -4,600. Consequently, buying 4,600 shares will neutralize delta.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-818-futures-delta-

and-dynamic-delta-hedging-hull-ch-19.20406/
8
P1.T4.819. Theta, gamma and vega for option positions

Learning objectives: Define and describe theta, gamma, vega, and rho for option
positions.
819.1. At a cost of $43,700.00, Robert enters a long position in 100 at-the-money call option
contracts; each contract is for 100 call options. The premium cost is $4.37 per option and the
options expire in about three months (60 trading days). The per-option theta is -9.630 per year.
There are 250 trading days in a year. He wants to estimate the effect of "time decay" on his
position. If twenty trading days (+ 20 days) elapse, but there is no change to the stock price,
volatility, or risk-free rate, then what is the expected impact on his position?
a) Loss of about $337.00

b) Loss of about $7,700.00
c) Gain of about $337.00
d) Gain of about $7,700.00
819.2. After Barbara wrote (i.e., sold) 100 put option contracts, the trade's position delta was
+7,200. The put options were in-the-money as the stock price was $70.00 while the options'
strike price was $100.00. Each contract was for 100 put options. The percentage gamma of
each put option was +0.0120. If the stock price subsequently, immediately decreased $10.00 to
$60.00, which is nearest to an estimate of the trade's new position delta?
a) -3,500
b) +7,200 (unchanged)
c) +8,400
d) +11,900
819.3. Patricia has a short position in 100 put option contracts where the per-option (aka,
percentage) vega is 33.50 and the stock's volatility is 30.0% per annum. The value of each
option is $8.77 and each contract is for 100 options. If the volatility jumps by +5.0% to 35.0%,
which is nearest to the estimated change in her position's value?
a) Loss of $16,750.00
b) Loss of $4,385.00
c) Loss of $1,469.00
d) Gain of $4,385.00
9
Answers:
819.1. B. True: Loss of about $7,700.00 = -9.63 * 20/250 * 100 * 100; the units of theta are Δ
dollars per Δ unit of time.
819.2. C. True: +8,400
The percentage delta of the short put position was 7,200/-10,000 = -0.720. Given a percentage
gamma of +0.0120, a drop of $10.00 in the stock price implies a change in delta given by -
$10.00 * 0.0120 = -0.120, such that the new delta would be -0.720 - 0.120 = -0.840. Notice that,
with the stock price drop, the put options become even more "in the money" and we do expect
the percentage delta to drop (toward its limit at -1.0). Consequently, the new position delta is -
10,000 * -0.840 = +8,400.
819.3. A. True: Loss of $16,750.00.
A vega of 33.50 implies the value of the option will increase (as a linear approximation only!) by
$33.50 per one unit increase in volatility, where one unit is 100%. Therefore a 5.0% increase in
volatility implies a change of 5.0% * 33.5 = $1.6750 but given Patricia has a short position in
100 contracts, her estimated LOSS is 5% * 33.50 * -10,000 = -$16,750.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-819-theta-gamma-

and-vega-for-option-positions-hull-ch-19.20986/
10
P1.T4.820. Delta- and gamma-neutral position; and the relationship

between delta, theta, and gamma
Learning objectives: Explain how to implement and maintain a delta-neutral and a
gamma-neutral position. Describe the relationship between delta, theta, gamma, and
vega.
820.1. Trader Joe (who is unrelated to the awesome grocery store!) takes a long position in 100
out-of-the-money (OTM) put option contracts when the non-dividend-paying stock price is
$88.00 and its volatility is 28.0%; each contract is for 100 options. The strike price is $80.00 and
the option term is six months. The risk-free rate is 5.0%. The value of each option is $4.38 and
the position's value is $43,800.00. With respect to these puts, the immediate percentage delta,
Δ = -0.2550 and gamma, Γ = 0.0130. If the stock price jumps by +$7.00 to $95.00, which
is nearest to the position's value as approximated by delta and gamma; i.e., without a full re-
pricing of the position?
a) $18,280
b) $25,950
c) $29,135
d) $33,640
820.2. Springshield is a market maker who has written a straddle for a client; this is a "top
straddle" or "straddle write" which entails selling a call and a put with the same exercise price
and expiration date. While the stock price is $90.00, the options' strike price is also $90.00 and
the maturity is 20 days. The stock's volatility is 18.0% and the riskless rate is 4.0%. The straddle
write includes 100 option contracts, and each contract is on 100 options. The position is almost
delta neutral; aka, the position delta is effectively zero. When the option maturity is twenty days,
the market maker's initial position theta is 228,678 and its position gamma is -1,735. If nothing
else changes (i.e., ceteris paribus such that the stock price, volatility, and riskfree rate are
unchanged), what happens to market maker's position theta and gamma after ten days later,
when the option maturity is only ten days?
a) Both position theta and position gamma increase; ie, theta more positive and gamma less
negative
b) Position theta increases (more positive) and position gamma decreases (more negative)
c) Position theta decreases (less positive) and position gamma increases (less negative)
d) Both position theta and position gamma decrease; theta less positive and gamma more
negative
11
820.3. Consider a portfolio that is delta neutral, with a gamma of -200 and a vega (measuring
sensitivity to implied volatility) of -5,000. The options shown in the following table can be traded.
The portfolio can be made vega neutral by including a long position in 125 of Option 2. This
would alter position delta to -48.75 and require that about 49 units of the asset be purchased to
maintain delta neutrality. The gamma of the portfolio would change from -200.0 to -168.75.
Which trade(s) will neutralize delta, gamma and vega? (this is a variation on Hull's example
19.5)
a) Short 1,333 of Option 1; Short 4,750 of Option 2; plus Long 800 of the underlying asset
b) Short 900 of Option 1; Long 2,000 of Option 2; plus Long 390 of the underlying asset
c) Long 1,650 of Option 1; Long 700 of Option 2; plus Short 500 of the underlying asset
d) Long 3,000 of Option 1; Short 1,000 of Option 2; plus Short 2,100 of the underlying asset
12
Answers:
820.1. C. True: $29,135
The delta-gamma approximated change is given by ΔS*Δ+ 0.5*Γ*(ΔS)^2; in this case of ΔS = +

7.00, estimated change = 7.0*(-0.2550)+ 0.5*(0.0130)*7.0^2 = -1.4665. Each option is estimated
to be worth $4.38 - $1.4665 = $2.9135 and the position is estimated to be worth $29,135.00.
In regard to false (B), $25,950 is the estimated value based on only a delta approximation; i.e., if
we exclude the gamma adjustment term.
The exact (re-priced with BSM) value is $28,841, so the approximation is off by about 1.0%.
820.2. B. True: Position theta increases (more positive) and position gamma decreases
(more negative)
No calculations are necessary: For at-the-money (ATM) options, percentage theta is negative
and decreasing as maturity approaches (as maturity converges toward zero). The long
straddle's position theta is negative, and the market maker (who is the "straddle write") has a
positive position theta that is increasing as expiration approaches. In this example, it happens to
an increase from 228,678 to 323,272 over the ten days. If the position is almost delta neutral,
then gamma has a directly inverse relationship with theta! Consequently, the market maker's
position gamma must be decreasing; in the case, the position gamma happens to decrease
from -1,1735 to -2,458.
From Hull 19.7: "19.7 RELATIONSHIP BETWEEN DELTA, THETA, AND GAMMA: The price of
a single derivative dependent on a non-dividend-paying stock must satisfy the differential
equation (15.16). It follows that the value of a portfolio of such derivatives also satisfies the
differential equation ... it follows that
Θ + 1/2*σ^2*S^2*Γ = r* Π.
This shows that, when is large and positive, gamma of a portfolio tends to be large and
negative, and vice versa. This is consistent with the way in which Figure 19.8 has been drawn
and explains why theta can to some extent be regarded as a proxy for gamma in a delta-neutral
portfolio."
13
820.3. D. True: Long 3,000 of Option 1; Short 1,000 of Option 2; plus Short 2,100 of the
underlying asset
We need to solve for two variables in two equations, as follows:

 -200 + 0.150*w1 + 0.250*w2 = 0,
 -5,000 + 15.0*w1 + 40.0*w2 = 0.
The solution is: w1 = 3,000, w2 = -1,000. This will neutralize gamma and vega but creates
position delta = 3,000 * 0.570 + (-1,000)*-0.390 = 2,100.0 such that 2,100 units of the asset
must be sold to neutralize delta (the asset has gamma of zero and vega of zero, so position
gamma and position vega are unaffected by this final trade).
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-820-delta-and-

gamma-neutral-position-and-the-relationship-between-delta-theta-and-gamma-hull-ch-
19.21016/
14
P1.T4.821. Delta hedging, scenario analysis and portfolio insurance

Learning objectives: Describe how hedging activities take place in practice, and describe
how scenario analysis can be used to formulate expected gains and losses with option
positions. Describe how portfolio insurance can be created through option instruments
and stock index futures
821.1. On Monday, a bank's position (the underlying portfolio) on the dollar-euro exchange rate
has an initial position delta of 11,300 and a position gamma of -25,000. The exchange rate is
EURUSD $0.860; i.e., per the currency priority convention, Euro is the base currency. By the
end of the week, on Friday, the exchange rate had jumped by +$0.050 to $0.910. The bank
entered two trades:
 On Monday, while the exchange rate is EURUSD $0.860, the bank's first trade
neutralized delta; aka, makes the net position "delta neutral"
 On Friday, after the exchange rate had increased to EURUSD $0.910, the bank's
second trade re-established the net position's delta neutrality
Which of the following were the bank's trades? Please note: this question is inspired by Hull's
EOC Problem 19.22.
a) Long 11,300 Euros on Monday, then short an additional 565 Euros on Friday
b) Long 25,000 Euros on Monday, then unwind (purchase) 565 Euros on Friday
c) Short 25,000 Euros on Monday, then short an additional 2,250 Euros on Friday
d) Short 11,300 Euros on Monday, then unwind (purchase) 1,250 Euros on Friday
15
821.2. Ozerholding Financial is a market maker who engaged in the following three option
trades. All three trades are options on the same equity index and a single contract is for 100
options.
 Long 100 option contracts where the percentage (per option) delta is +0.620 and the
percentage (per option) vega is +31.50
 Short 100 option contracts where the percentage (per option) delta is -0.450 and the
 Short 100 option contracts where the percentage (per option) delta is -0.530 and the
Ozerholding then conducts a scenario analysis to estimate the possible gain/loss on the
portfolio that consists of all three option positions. The scenario analysis contemplates five
possible changes to each of the index price and its implied volatility, as below:
In which quadrant is the greatest potential LOSS to Ozerholding located?
a) The upper-left where both the index price and implied volatility decrease
b) The upper-right where the index price increases but the implied volatility decreases
c) The lower-left where the index price decreases but the implied volatility increases
d) The lower-right where both the index price and implied volatility increase
16
821.3. A fund manager has a well-diversified portfolio that mirrors the performance of the S&P
500 equity index and is worth $100.0 million. The value of the S&P 500 index is 2,800 and the
portfolio manager would like to buy insurance against a reduction of more than 5.0% in the
value of the portfolio over the next nine months. The risk-free interest rate is 5.0% per annum.
The dividend yield on both the portfolio and the S&P 500 is 2.0%, and the volatility of the index
is 22.0% per annum. If the fund manager were to insure by buying traded European put options,
the cost of insurance would be about $4,238,870 = $118.69 * ($100,000,000 / 2,800) where
$118.69 is the price of a put option with S(0) = 2,800, K = 2,660, σ = 22.0%, riskfree rate =
5.0%, dividend yield = 2.0%, and T = 0.75 years. The delta of the put is given by exp(-
q*T)*[N(d1) - 1] = exp(-0.020*0.75)*[0.68530 - 1] = -0.3100.
Instead, the fund manager decides to provide insurance by using one-year (T = 1.0 year) index
futures. Which of the following is nearest to the index futures trade that synthetically creates the
put options in order to insure the portfolio? Please note: this question is difficult and is inspired
by Hull's example 19.10 and his EOC Problem 18.16.
a) Short 43 index futures contracts

b) Short 125 index futures contracts
c) Short 190 index futures contracts
d) Short 300 index futures contracts
17
Answers:
821.1. D. Short 11,300 Euros on Monday, then unwind (purchase) 1,250 Euros on Friday
The positive delta of 11,300 signifies that, for example, if the exchange rate increases by
$0.010, then the value of the portfolio increases by $0.01 * 11,300 = +$113.00. An increase in
the EURUSD exchange rate reflects appreciation in the Euro (the base currency) and
depreciation in the US dollar (the quote currency). Therefore, the position experiences a loss in
value when the exchange rate decreases (per positive delta) which represents a depreciation of
the Euro (i.e., an appreciation in the USD). To neutralize this delta requires a SHORT position in
11,300 Euros.
The gamma of -25,000 signifies that delta changed by ($0.91 - $0.86) * (-25,000) = -1,250.0
when the exchange rate changed from $0.860 to $0.910. Consequently, as of Friday, the
portfolio's new position delta = 11,300 - 1,250 = 10,050. To maintain delta neutrality, the second
trade unwind 1,250 so that it's short Euro position is 10,500.
821.2. C. The lower-left where the index price decreases but the implied volatility
increases
The portfolio's net position delta is +16,000 and its net position vega is -55,000. Consequently,
its value drops on a decrease in the index price (per positive delta) and drops on an increase in
volatility (per negative position vega). Here is the portfolio's net position delta and vega:
821.3. A. True: Short 43 index futures contracts
As the put's delta is -0.3100, if the fund manager were to provide insurance by keeping part of
the portfolio in risk-free securities, she would sell about 0.310 * $100.0 million = $31.0 million
from the portfolio and invest the proceeds in risk-free securities. The required short position is
$31,000,000 / 2,800 = 11,072 times the index. Therefore, where the delta of a one-year futures
contract is given by exp[(r-q)*T] = exp[(0.050 - 0.020)*1.0] = 1.030, the number of short futures
contracts = 11,072 / (250 * 1.030) = 42.98.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-821-delta-hedging-

scenario-analysis-and-portfolio-insurance-hull-ch-19.21029/
18

AIM: Compute the delta of an option. Describe the dynamic aspects of delta hedging.
Define the delta of a portfolio.
400.1. The riskfree rate is 3.0% per annum while the price of a non-dividend-paying stock is
$120.00. For a European call option with a strike price of $100.00 and one year maturity, the
Black-Scholes-Merton (BSM) option pricing model returns $27.50 for the value of this in-the-
money call; i.e., S(0) = $120.00, K = $100.00, σ = 30%, T = 1.0 year, and r = 3.0% informs price
of (c) = $27.50. The risk-neutral probability that the option will be exercised (equivalently, that it
will expire in-the-money), N(d2), is 71.0%. Which is nearest to the option's delta?
a) 0.559
b) 0.620
c) 0.714
d) 0.803
400.2. Consider the following four statements about the delta of option (ceteris paribus implied
throughout):
I. As the expiration date approaches (as maturity tends to zero), the delta of an in-the-
money (ITM) call (put) option tends away from zero and toward 1.0 (-1.0)
II. As the expiration date approaches (as maturity tends to zero), the delta of an out-of-the-
money (OTM) call or put option tends toward zero
III. As volatility increases, the delta of an in-the-money (ITM) call (put) decreases
(increases)
IV. As volatility increases, the delta of an out-of-the-money (OTM) call (put) increases
(decreases)
Which of the above statements is (are) TRUE?
a) None are true

b) I. and III. Only
c) II. and IV only
d) All are true
19
400.3. Suppose a financial institution has a portfolio that contains the following four positions in
options on a stock:
1. A long position in 20,000 call options and the delta of each of these option is 0.620.
2. A short position in 10,000 call options and the delta of each of these options is 0.550.
3. A long position in 20,000 put options and the delta of each of these options is -0.470.
4. A short position in 10,000 put options and the delta of each of these options is -0.430.
Which trade will make the portfolio delta neutral?
a) Short 1,800 shares

b) Short 4,350 shares
c) Long 2,250 shares
d) Long 3,700 shares
20
Answers:
400.1. D. 0.803
Because c = S(0)*N(d1) - K*exp(-rT)*N(d2) -->
N(d1) = [c + K*exp(-rT)*N(d2)]/S(0) = [$27.50 + $100*exp(-0.03*1.0) * 0.710]/$120 = 0.8033
400.2. D. All are true
In regard to III and IV,

 In regard to a call option, recall its delta lies on the interval (0,1), a deep OTM call will
have a delta near zero but increasing as volatility increases. A deep ITM call will have a
delta near to 1.0 but decreasing as volatility increases
 In regard to a put option, recall its delta lies on the interval (-1,0), a deep OTM put will
have a delta near zero but decreasing (toward -0.5, eg) as volatility increases. A deep
ITM put will have a delta near to -1.0, but increasing (toward -0.5, eg) as volatility
increases.
400.3. A. Short 1,800 shares

The position delta of the portfolio = (+1)*20,000*0.620 + (-1)*10,000*0.550 + (1)*20,000*-0.470
+ (-1)*10,000*-0.430 = +1,800.
Therefore to neutralize delta, the trade is to short (sell) 1,800 shares (each share has a delta of
1.0).
Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-400-option-delta.7651/
21
P1.T4.401. Option gamma

AIM: Define and describe ... gamma for option positions. Describe the relationship
between delta, theta, and gamma.
401.1. Consider the following about a European call option with one year maturity and strike
price of $100.00 while the stock's volatility is 30.0% per annum and the riskfree rate is 2.0%:
 When the stock price is $100.00, the option's delta is 0.5860
 When the stock price increases by $1.00 to $101.00, the option's delta increases to
0.5990
Which is the BEST estimate of the option's gamma when the stock price is $100?
a) 0.0130
b) 0.2600
c) 52.0
d) 104.0
401.2. Given that N(d1) is the delta of European call option, what is true about the shape of the
plot of the option's gamma (y-axis) against the stock price (x-axis)?
a) It is a normal probability density function (pdf)
b) It is a normal cumulative distribution function (CDF)
c) It is a log-normal cumulative distribution function (CDF)
d) We need the option parameters
401.3. Each of the following is true about option gamma, EXCEPT which is false?
a) For a short-life option, as expiration approaches (i.e., as maturity decreases to zero), the
gamma of both in-the-money (ITM) and out-of-the-money (OTM) options tends toward zero
b) For a short-life option, as expiration approaches (i.e., as maturity decreases to zero), the
gamma of an at-the-money (ATM) option tends toward zero
c) If you write a covered call, you are short gamma; i.e., position gamma is negative
d) If you purchase a protective put, you are long gamma; i.e., position gamma is positive
22
Answers:
401.1. A. 0.0130. Gamma is the first partial derivative (slope) of delta: rise/run = (0.5990 -
0.5860)/(101-100) = .0130.
The rest of the information is not here necessary.
Note this is a linear approximation (i.e., the secant near to the tangent), but it's very close (even
as the deltas are themselves rounded) to the exact analytical gamma (at K = 100) of 0.129896
401.2. A. It is a normal probability density function (pdf).

Delta is N(d1) and N(.) is the normal cumulative distribution function (normal CDF). As gamma
is the first derivative, the shape of gamma is the normal pdf!
401.3. B. Although for short-life OTM/ITM options, gamma tends to zero as maturity
decreases toward zero, at-the-money options behave the opposite way: the gamma of
ATM options is generally a decreasing function of maturity (i.e., gamma increases as maturity
tends toward zero).
Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-401-option-gamma.7665/
23
P1.T4.402. Option vega

AIM: Define and describe ... vega for option positions
402.1. Consider an option with a vega of 38.20 while the underlying stock's volatility is 20.0%
per annum with continuous compounding. Which of the following is the BEST interpretation?
a) If the volatility increases by 10 basis points from 20.00% to 20.10%, then the price of the
option will increase by approximately $3.82
b) If the volatility increases by 100 basis points from 20.0% to 21.0%, then the price of the
c) If the volatility increases by 100 basis points from 20.0% to 21.0%, then the price of the
d) If the volatility increases by 1,000 basis points from 20.0% to 30.0%, then the price of the
402.2. Consider the following call option which is re-priced after a mild + 3.0% shock to its
volatility. In both cases, the stock = strike = $50 (i.e., at an-the-money call option), the riskfree
rate is 2.0% and the maturity is one year:
 When volatility is 30.0%, the option price is $6.41
 When volatility increases to 33.0%, the option price is $6.99
Which is nearest to the option's vega?

a) 0.19
b) 0.580
c) 19.33
d) 58.40
402.3. Recall that option vega is given by S(0)*sqrt(T)*N'(d1). Each of the following is true about
vega EXCEPT which is false?
a) Vega tends to increase with option maturity

b) Vega is highest for at-the-money options (compared to ITM and OTM options)
c) If the stock price doubles, vega approximately doubles
d) Per put-call parity, the vega above is the same for both a call and a put with an identical
strike price and maturity
24
Answers:
402.1. B. If the volatility increases by 100 basis points from 20.0% to 21.0%, then the price
of the option will increase by approximately $0.3820 = +1.0% change in vol * $38.20
price/change in vol
Vega is approximate (first partial derivative) change in option price per one unit (100%) change
in volatility. A Vega of 38.2 implies a $38.20 change per 100%, such that a +1.0% change in
volatility is associated with a price change of 1.0% * $38.20 = $0.3820
402.2. C. 19.33 = (6.99 - 6.41)/(0.33 - 0.30)
402.3. C. False, this contradicts true (B). For example, if the stock price doubles, the vega will
decrease for an ATM option; keep in mind vega is a first (partial) derivative, the value of the
option will still increase even as vega drops.
In regard to (A), (B) and (D), each is TRUE.
Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-402-option-vega.7672/
25
P1.T4.403. Option theta

AIM: Define and describe ... theta for option positions.
403.1. Consider an at-the-money (ATM) European call option with strike price of $100.00 while
the underlying non-dividend-paying stock's volatility is 30.0% per annum. The riskfree rate is
3.0%. Here are option's prices at three different maturities:
 With a maturity of two years, the option price is $19.38
 With a maturity of three years, the option price is $24.21
 With a maturity of four years, the option price is $28.33
Which of the following is approximately this option's theta when it has a maturity of three years?
a) about -4.4 per year
b) about -2.9 per year
c) about -0.0178 per year
d) about +0.4 per year
403.2. Assume 250 trading days in the year. When the underlying stock has a volatility of 50.0%
per annum and the risk-free rate is 4.0%, an at-the-money (ATM) European call option, with a
strike price of $100.00 and a maturity of 125 trading days (0.5 years), has a price of $14.90 and
a theta of -15.50 per year. Which is a good approximation of the option's price in ten (10) days,
if no other variables change?
a) $12.74
b) $13.90
c) $14.28
d) $15.15
NOTE: Please see the forum regarding a comment by David that question 403.3 needs to
be fixed.
403.3. Each of the following is true about theta, EXCEPT which is false?
a) The theta of a European call option is always negative
b) The theta of a European put option is always negative
c) The theta of a put exceeds the theta of a corresponding call (i.e., with identical strike price
and maturity) by r*K*exp(-r*T)
d) For an at-the-money (ATM) option, as an option approaches expiration, its theta tends away
from zero and becomes increasingly negative (i.e., decreases)
26
Answers:
403.1. A. about -4.4 years, which is the average of the price changes given at three years:
4.46 = average of (24.21 - 19.38) and (28.30 - 24.21).
Note the exact, analytical theta at three years is -4.422 years.
403.2. C. $14.28. $14.90 - ($15.50 * 10/250) = $14.28 (actual price is $14.2725)
NOTE: Please see the forum regarding a comment by David that question 403.3 needs to
be fixed.
403.3. B. False. Theta is generally negative (time decay tends to decrease an option's
value), but the salient exception is an in-the-money (ITM) put option.
In regard to (A), (C) and (D), each is TRUE.
Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-403-option-theta.7686/
27
P1.T4.404. Neutralizing option position Greeks

AIM: Explain how to implement and maintain a gamma neutral position
404.1. A European call option has a (percentage) delta of 0.580. A trader creates a straddle by
purchasing 1,000 of the call options and 1,000 put options with identical strike and maturity.
However, the trader wants to neutralize delta. Which of the following trades, when added to the
straddle, will neutralize the total position's delta?
a) Short 1,380 of the call options
b) Short 160 of the underlying shares
c) Long 720 of the put options
d) No additional trade required as the straddle is already delta neutral
404.2. Robert the Trader has already written 1,000 call options with (percentage) delta of 0.670
and gamma of 0.090 such that his position delta is -670.0 and his position gamma is -90.0. He
can buy or sell another call option on the stock; this additional call option has (percentage) delta
of 0.560 and gamma of 0.150. Which trade will neutralize delta and gamma?
a) Buy 600 call options and buy 334 of the underlying shares
b) Buy 400 call options and sell 215 of the underlying shares
c) Sell 300 call options and buy 180 of the underlying shares
d) Sell 260 call options and sell 155 of the underlying shares
404.3. A portfolio has the following position Greeks: delta = -300, gamma = -150, and vega = -
3,000. A trader wants to neutralize all three Greeks and, in addition to the underlying shares,
can use the following two options:
 Call option with the following percentage Greeks: delta = 0.60, gamma = 0.20, and vega
= 10.0
 Put option with the following percentage Greeks: delta = -0.40, gamma = 0.30, and vega
= 20.0
Along with the underling shares, which set of trades will make the total position delta-gamma-
vega neutral? (hint: first make the portfolio gamma-vega neutral, then use shares to neutralize
delta)
a) Short 800 of the calls; long 150 of the puts, and short 500 of the underlying shares
b) Short 1,500 of the calls; short 680 of the puts, and long 770 of the underlying shares
c) Long 2,100 of the calls; short 900 of the puts; and short 1,320 of the underlying shares
d) Long 3,000 of the calls; short 1,750 of the puts; and long 540 of the underlying shares
28
Answers:
404.1. B. Short 160 of the underlying shares

As the put has delta = N(d1) - 1 = 0.58 - 1 = -0.42, the straddle has position delta = (+1,000 *
0.58) + (+1,000 * -0.42) = 580 - 420 = +160, which is neutralized by shorting 160 shares
404.2 A. Buy 600 call options and buy 334 of the underlying shares
First, he can neutralize gamma with -(-90)/0.15 = long +600 options; then, total gamma = -90 *
(+600 * 0.15) = 0.
But delta = -670 + (+600 * 0.560) = =334.0 such that long 334 shares are required to neutralize
delta (and these shares do not impact gamma as the percentage gamma of shares is zero).
404.3. C. Long 2,100 of the calls; short 900 of the puts; and short 1,320 of the underlying
shares
Let x = number of call options and y = number of put options. Gamma and vega neutrality are
implied by:
Gamma neutral: -150 + 0.20*x + 0.30*y = 0 --> 0.20*x + 0.30*y = 150, and
Vega netural: -3,000 + 10*x + 20*y = 0 --> 10*x + 20*y = 3,000.
This is two equations and two unknowns such that x = 2,100 and y = -900.
The delta of this gamma-vega neutral portfolio = -300 + 2100*0.60 - 900*(-0.40) = 1,320 such
that short 1,320 will neutralize delta.
Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-404-neutralizing-option-position-

greeks.7693/
29

AIM: Define delta hedging for an option, forward, and futures contracts. Define and
compute delta for an option.
6.1. What is, respectively, the delta of an at-the-money (ATM) six-month European call and put
option on a non-dividend-paying stock when the riskless rate is 4.0% per annum and the stock
price volatility is 28%?
a) 0.20 (ATM call) and -0.20 (ATM put)
b) 0.20 (ATM call) and -0.80 (ATM put)
c) 0.58 (ATM call) and -0.58 (ATM put)
d) 0.58 (ATM call) and -0.42 (ATM put)
6.2. A trader has a short position in 1,000 at-the-money (ATM) one-year put options when the
underlying stock price has a volatility of 20% per annum and the riskless rate is 4.0% per
annum. Which trade will make the position delta neutral?
a) Long 382 shares
b) Short 382 shares
c) Long 618 shares
d) Short 618 shares
6.3. The spot EUR/USD exchange rate is $1.30 (i.e., USD 1.30 per 1 EUR) with a volatility of
30% per annum. The USD riskless rate is 4% per annum and the EUR riskless rate is 3% per
annum. What is the delta of a one-year call option on the Euro with a strike price of EUR/USD
$1.36?
a) 0.4980
b) 0.5131
c) 0.5529
d) 0.6078
30
6.4. The spot price of oil is $80.00 per barrel with a volatility of 26% per annum. The riskfree
rate is 5.0% per annum. What is the delta of a one-year futures contract when the one-year
futures price is $90.00 per barrel?
a) 0.951
b) 1.000
c) 1.051
d) 1.118
6.5. The current price of the S&P 500 Index is 1200. The one-year futures price is 1262; i.e.,
+5% continuously compounded. The volatility of the index is 18% per annum and the dividend
yield is 2.0% per annum. If the riskfree rate is 4.0% per annum, what is the detla of the the one-
year futures contract on the S&P 500 Index?
a) 0.9802
b) 1.0000
c) 1.0202
d) d. 1.0408
6.6. In sequence FROM LOWEST to highest value of option delta, what is the correct order of
the following four options: in-the-money (ITM) call option, out-of-the-money (OTM) call option,
in-the-money (ITM) put option, and out-of-the-money (OTM) put option?
a) OTM put, OTM call, ITM call, ITM put
b) OTM call, ITM call, ITM put, OTM put
c) ITM call, ITM put, OTM put, OTM call
d) ITM put, OTM put, OTM call, ITM call
31
Answers:
6.1. D. 0.58 (ATM call) and -0.42 (ATM put)

d1 = [LN(S/K) + (4% + 28%^2/2)*0.5] / [28% * SQRT(0.50)]. If S=K, then LN(S/K) = LN(1) = 0,
such that:
d1 = [0 + (4% + 28%^2/2)*0.5] / [28% * SQRT(0.50)] = 0.2000
call delta = N(d1) = 0.5793, such that
put delta = N(d1) - 1 = -0.4207
6.2. B. Short 382 shares

d1 = [LN(S/K) + (Rf + sigma^2/2)*T] / [sigma * SQRT(T)]. If S=K, then LN(S/K) = LN(1) = 0, such
that:
d1 = [0 + (4% + 20%^2/2)*1] / [20% * SQRT(1)] = 0.3000
Put percentage delta = N(d1) - 1 - 0.6179 = -0.3821, so that
Position delta = quantity * percentage delta = -1000 * -0.3821 = 382
To neutralize, we need -328 position delta, which is short 328 shares.
6.3. A. 0.4980
We substitute the foreign riskfree rate for the dividend yield:
d1 = [LN(S/K) + (Rf_USD - Rf_EUR+ sigma^2/2)*T] / [sigma * SQRT(T)], so that:
d1 = [LN(1.30/1.36) + (4% - 3% + 30%^2/2)*1] / [30% * SQRT(1)] = 0.0329, and
N(d1) = 0.5131, and again substitute the foreign riskfree rate for the dividend yield:
delta of call = N(d1) * exp(-qT) = 0.5131 *exp(-3%*1) = 0.4980
6.4. C. 1.051
Delta of forward = exp(-qT) and delta of futures = exp[(r-q)*T]. In this case, delta = exp(5%) =
1.051.
The other information is unnecessary.
6.5. C. 1.0202
Delta = exp[(r-q)*T] = exp[(4%-2%)*1] = 1.0202
6.6. d. ITM put, OTM put, OTM call, ITM call

ITM put has lowest value as deep ITM put approaches -1.0
OTM put has next highest value as deep OTM put approaching zero but always negative
OTM call has next highest value as deep OTM call approaching zero but always positive, and
ITM call has highest value as deep ITM call approaching 1.0
Discuss in forum here: http://www.bionicturtle.com/forum/threads/p1-t4-6-option-delta.4829/
32
P1.T4.7. Dynamic delta hedging

AIMs: Discuss the dynamic aspects of delta hedging. Define the delta of a portfolio.
7.1. Yesterday, a market maker sold (wrote) 100 at-the-money (ATM) call options when the
percentage delta was 0.57. The market maker immediately started a daily dynamic delta hedge
by purchasing the underlying shares to achieve a a position delta of zero (i.e., to neutralize
delta). Today, the share price dropped such that the call option percentage delta reduced to
0.54. What is today's dynamic delta hedge trade?
a) Buy 3.0 shares
b) Sell 3.0 shares
c) Buy 54.0 shares
d) Sell 54.0 shares
7.2. Today, a market maker takes a short position in 100 at-the-money (ATM) put options (i.e.,
writes or sells puts) when the percentage delta was -0.48. The market maker immediately starts
a dynamic delta hedge by trading the underlying shares to neutralize delta. Tomorrow, if the
stock price drops and the percentage delta drops to -0.53, what will be tomorrow's dynamic
delta hedge trade?
a) Sell 5.0 shares
b) Buy 5.0 shares
c) Sell 53.0 shares
d) Buy 53.0 shares
7.3. A market maker today writes 100 at-the-money (ATM) call option contracts (i.e., short
10,000 options) and immediately starts a dynamic delta hedge by purchasing the underlying
non-dividend-paying shares, but due to transaction costs will only re-balance weekly. Next week
the underlying share price, volatility and riskfree rate are unchanged. What is the next week's
dynamic delta hedge trade?
a) Sell some amount of shares (reduced long position in shares)
b) No transaction (maintain long position in shares)
c) Buy some amount of shares (increase long position in shares)
d) Not enough information (we need the option delta)
33
7.4. A market maker is trading the following three (3) positions in call and put options which are
identical with respect to their underlying stock price, the strike price and the maturities: long 100
ATM call options with a percentage delta of 0.6; short 60 ATM call options; and long 50 ATM put
options. Which trade will neutralize the market maker's delta?
a) Buy 6.0 shares
b) Sell 6.0 shares
c) Buy 4.0 shares
d) Sell 4.0 shares
7.5. A market maker writes 100 at-the-money call option contracts and delta hedges
dynamically by daily rebalancing of a long position in the underlying shares. The delta hedge is
based on an implied volatility assumption of approximately 10% per annum. However, at the
end of the month, the realized (actual subsequent) volatility of the stock was over 20%.
However, the stock fluctuated both up and down roughly evenly. If borrowing occurs at the
constant riskfree rate, and transaction costs are ignored, what is the net profit (loss) to the
market maker at the end of the month?
a) Net loss due to gamma exposure
b) Net loss due to theta (time decay)
c) Approximately break-even due to the almost continuous delta hedge and roughly even
up/down movements
d) Net gain due to the gamma exposure
34
Answers:
7.1. B. Sell 3.0 shares

The option position delta changed by -100 * (0.54 - 0.57) = +3.0 such that 3.0 shares are sold.
Put another way,
Yesterday: the option position delta was -100*0.57 = -57; this required the purchase of 57
shares to achieve delta neutral.
Yesterday's position = short 100 call options [@ 0.57 per option delta] + long 57 shares.
Today: the option position changed to -100*0.54 = -54; three shares must be sold to reduce the
share delta from 57 to 54.
Today's position = short 100 call options [@ 0.54 per option delta] + long 54 shares.
7.2. A. Sell 5.0 shares

The short version is that the option position delta changed by -100 * (-0.53 - (-0.48)) = -100 * -
0.05 = +5.0, such that the market maker sells 5.0 shares (i.e., position delta = -5.0) to
neutralize.
Put another way,
Today: the option position delta = -100 * -0.48 = +48; this requires the sale of 48 shares to
achieve delta neutral.
Today's position = short 100 put options [@ -0.48 per option delta] + short 48 shares.
Tomorrow: the option position delta changes to -100 * -0.53 = +53; five shares must be sold to
achieve delta neutral.
Tomorrow's position = short 100 put options [@ -0.53 per option delta] + short 53 shares.
7.3. A. Sell some amount of shares (reduced long position in shares)

Next week, the percentage delta due to a slightly shorter maturity, ceteris paribus, must be
slightly lower. The position delta on the written calls must therefore INCREASE from a negative
to a slightly higher negative. For example, if today's percentage delta is 0.57 and, due only to a
maturity of one week less, next week's percentage delta is 0.56, then the position delta
increases from -5,700 to -5,600. As today's delta hedge is long 5,700 shares, next week 100
shares must be sold to maintain delta neutrality.
7.4. D. Sell 4.0 shares

First call position delta = +100 long quantity * 0.6 = +60 position delta;
Second call position delta = -60 short quantity * 0.6 = -36 position delta;
Put position delta = +50 long quantity * -0.4 percentage delta = - 20 position delta; i.e., put delta
= N(1) - 1 = call delta - 1 = 0.6 - 1
Total position delta = +60 - 36 - 20 = +4, such that short 4 shares will neutralize delta.
35
7.5. A. Net loss due to gamma exposure

If the realized volatility matched the assumed volatility (which informs the delta!), then the
market maker should be roughly break-even due to the delta-hedge; this is another way of
viewing Hull's statement that the discounted cost of hedging should roughly equal the Black-
Scholes price.
However, the market marker, who is short options, remains "short gamma" (aka, "long short
convexity"); i.e., the long shares have per share delta of 1.0 but gamma of zero (do you see
why? the delta of 1.0 does not vary). The market maker's option counterparty, on the other
hand, is "long gamma."
In this case, a realized volatility higher than assumed implies losses to the short gamma
position.
In regard to (B), while time decay has a second-order impact on gamma (i.e., for ATM options,
gamma increases as time to maturity decreases; so this effect only compounds the short
gamma), the shorter maturity is already re-computed in each daily re-balancing.
Discuss in forum here: http://www.bionicturtle.com/forum/threads/p1-t4-7-dynamic-delta-

hedging.4838/
36
P1.T4.8. Option Greeks

AIM: Define, compute and describe theta, gamma, vega, and rho for option positions.
8.1. Twelve days ago (T - 12 days), a European call option with a price of $4.80 had a theta of -
6.30 per year. Between then and today (T0), no stochastic option inputs have changed; i.e.,
stock price, volatility and riskfree rate are unchanged. What is the today's estimate of the option
price, as reduced by only time decay, assuming 252 trading days per year?
a) $3.36
b) $4.50
c) $4.63
d) $4.77
8.2. An at-the-money call option has a (percentage) delta of 0.600 and gamma of 0.030. A
market maker writes (sells) 100 call options, but only after the stock price unexpectedly jumps
$2.00, so the written options are immediately in-the-money by $2.00. How many shares should
the market maker buy to neutralize the delta of the option position?
a) Long 3.0 shares
b) Long 60.0 shares
c) Long 63.0 shares
d) Long 66.0 shares
8.3. Which is likely to have the highest gamma?

a) Deep in-the-money call option that is near to expiration
b) Deep out-of-the-money put option that is near to expiration
c) At-the-money put option that is very distant from expiration
d) At-the-money call option that is near to expiration
8.4. A call option with a price of $3.52 has a vega of 18.50. If the volatility increases from 20.0%
to 26.0% per annum, what is the estimated price of the option under the higher volatility?
a) $3.69
b) $4.63
c) $8.33
d) $9.07
8.5. If at-the-money (ATM) options are otherwise identical, which of the following will have the
LOWEST value of rho?
a) Put with distant time to expiration
b) Put near to expiration
c) Call near to expiration
d) Call with distant time to expiration
37
Answers:
8.1. B. $4.50
Estimated change in option value = $-6.30 * 12/252 = $-0.30.
Estimated option price = $4.80 + ($-6.30 * 12/252) = $4.50
8.2. D. Long 66.0 shares

Gamma is the change in delta given a change in the stock price, such that if the stock price
increases by $2.00, we expect the "percentage delta" to increase by 2.00 * 0.030 = 0.060 to
0.660; i.e., new delta = 0.60 + (2 * 0.030) = 0.660. The position delta is therefore -100 * 0.660 =
-66, such that 66 shares are purchased to neutralize delta.
8.3. D. At-the-money call option that is near to expiration

The gamma of a call and put, if inputs are equal, is identical, so call/put does not matter here.
The gamma of both deeply in- or out-of-the-money options tends toward zero. (think about the
almost-flat slope of the delta line as it converges to 0.0 or 1.0).
For an at-the-money option, gamma increases as time to expiration decreases; gamma is
generally highest for ATM options with short expirations.
8.4. B. $4.63
change in option price = 0.06 * 18.5 = $+1.11, such that new estimated option price = $3.52 +
$1.11 = $4.63
8.5. A. Put with distant time to expiration

Rho is positive for calls and negative for puts, with interest rate having the most impact when
expiration is distant.
Rho (put) = -K*T*exp(-rT)*N(-d2), such that Rho(put) is a decreasing function with increasing
(T).
Discuss in forum here: http://www.bionicturtle.com/forum/threads/p1-t4-8-option-greeks.4848/
38
P1.T4.9. Gamma-neutral option positions

AIMs: Explain how to implement and maintain a gamma‐ neutral position. Discuss the
relationship between delta, theta, and gamma. Describe how hedging activities take place
in practice, and discuss how scenario analysis can be used to formulate expected gains
and losses with option positions. Describe how portfolio insurance can be created
through option instruments and stock index futures.
9.1. A delta-neutral option portfolio has a position gamma of +300. If call options have a
(percentage) delta of 0.58 and gamma of 0.120, what trades will neutralize the delta and
gamma of the portfolio?
a) Long 1,500 put options and sell 950 shares
b) Short 1,500 put options and buy 950 shares
c) Long 2,500 call options and sell 1,450 shares
d) Short 2,500 call options and buy 1,450 shares
9.2. A market maker writes (sells) a contract of 100 call options, where the percentage (per
option) delta of the call options is 0.60 and the gamma is 0.080. The market maker wants to
neutralize both the delta and gamma of this position (delta-gamma-neutral) with two additional
trades: the underlying shares; and put options on the stock with percentage delta of -0.40 and
gamma of 0.020. What are the trades?
a) Buy 200 put options and buy 80 shares
b) Sell 200 put options and sell 80 shares
c) Buy 400 put options and buy 220 shares
d) Sell 400 put options and sell 220 shares
9.3. Hull (equation 17.4) shows that the relationship between theta, delta and gamma is given
by: theta + (Rf * S * delta) + (0.5*variance(S)*S^2*gamma) = Rf*Value(option portfolio), where
(Rf) is the riskfree rate and (S) is the stock price. The price of a one-year European call option
with a strike price of $100 is $13.75 when the stock price is also $100. The volatility is 30.0%
and the riskfree (Rf) rate is 4.0% per annum. The option's (percentage) delta is 0.612 and
gamma is 0.0128. What is the option's theta?
a) -5.333
b) -7.658
c) -9.112
d) -11.115
39
9.4. A delta-neutral option portfolio has a large and positive position theta. Which of the
following trades is most likely to neutralize the portfolio's gamma?
a) Buy call options
b) Write put options
c) Sell shares
d) None of the above: theta must be negative!
9.5. A portfolio of short calls and short puts is delta-neutral and the options are, on average, at-
the-money (ATM) with near-term maturities. Which of the following is most likely true about the
portfolio's theta?
a) Large and negative
b) Small and negative
c) Small and positive
d) Large and positive
40
Answers:
9.1. D. Short 2,500 call options and buy 1,450 shares

To neutralize position gamma of +300, short 300/0.12 = 2,500 call options; i.e., -2,500 * 0.12 = -
300.
But this creates -2,500 * 0.58 = -1,450 position delta, so buy 1,450 shares.
9.2. C. Buy 400 put options and buy 220 shares

The written options have position delta = -100 * 0.60 = -60.0; and position gamma of -100 *
0.080 = -8.0.
The puts must be used to neutralize the position (as the shares have zero gamma).
As 8.0/0.020 = 400, 400 put options must be purchased to neutralize gamma: +400 * 0.020 =
+8.0 which neutralizes the -8.0.
But the long 400 put options reduced (added negative) position delta = +400 * -0.40 = -160.0
such that the cumulative position delta = -60.0 + -160.0 = -220.0.
Therefore, the market maker must purchase 220 shares (with +1.0 delta each) to neutralize
delta.
To summarize, the final position:

Delta = (-100 * 0.60) + (+400 * -0.40) + (220 * 1.0) = 0; and
Gamma = (-100 * 0.080) + (+400 * 0.020) + (220 * 0) = 0.
9.3. B. -7.658
Just apply the equality, solving for theta
If: theta + (Rf * S * delta) + (0.5*variance(S)*S^2*Gamma) = Rf*Value(option portfolio), then
theta = Rf*Value(option portfolio) - (Rf * S * delta) - (0.5*variance(S)*S^2*Gamma).
theta = 4%*13.75 - (4% * 100 * 0.612) - (0.5*30%^2*100^2*0.0128) = -7.658
9.4. A. Buy call options

Percentage theta is typically negative. A SHORT option position, in either calls or puts, therefore
typically has positive position theta . Nevertheless, per Hull 17.4, in a delta-neutral portfolio, a
large and positive position theta implies a large and negative position gamma. To neutralize
gamma, the trade needs to add positive position gamma; i.e., either buy calls or puts.
 In regard to (B), writing puts adds negative position gamma.
 In regard to (C), shares have zero gamma (i.e.., constant delta = 1.0).
9.5. D. Large and positive

As the maturity decreases, the position gamma of ATM options tends to increase (decrease) for
long (short) options. Short call options and short put options both have negative position
gamma. Therefore, portfolio of entirely short positions in generally near-term, ATM options will
tend to have a large and negative position gamma.
Per Hull: Theta + (Rf * S * delta) + (0.5*variance(S)*S^2*Gamma) = Rf*Value(option portfolio),

but if delta = 0 (delta neutral), then:
Theta + (0.5*variance(S)*S^2*Gamma) = +constant, such that:
If delta-neutral, then, the theta will tend to be large and positive.
Discuss in forum here: http://www.bionicturtle.com/forum/threads/p1-t4-9-gamma-neutral-

option-positions.4867/
41
Hull: Options, Futures & Other Derivatives – Chapter 19 Q&A

Problem 19.1.
Explain how a stop-loss trading rule can be implemented for the writer of an out-of-the-money
call option. Why does it provide a relatively poor hedge?
Answer:
Suppose the strike price is 10.00. The option writer aims to be fully covered whenever the
option is in the money and naked whenever it is out of the money. The option writer attempts to
achieve this by buying the assets underlying the option as soon as the asset price reaches
10.00 from below and selling as soon as the asset price reaches 10.00 from above. The trouble
with this scheme is that it assumes that when the asset price moves from 9.99 to 10.00, the next
move will be to a price above 10.00. (In practice the next move might back to 9.99.) Similarly it
assumes that when the asset price moves from 10.01 to 10.00, the next move will be to a price
below 10.00. (In practice the next move might be back to 10.01.) The scheme can be
implemented by buying at 10.01 and selling at 9.99. However, it is not a good hedge. The cost
of the trading strategy is zero if the asset price never reaches 10.00 and can be quite high if it
reaches 10.00 many times. A good hedge has the property that its cost is always very close the
value of the option.
Problem 19.2.
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 each option is 0.7?
Answer:
A delta of 0.7 means that, when the price of the stock increases by a small amount, the price of
the option increases by 70% of this amount. Similarly, when the price of the stock decreases by
a small amount, the price of the option decreases by 70% of this amount. A short position in
1,000 options has a delta of 700 and can be made delta neutral with the purchase of 700
shares.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/hull-15-02.3823/#post-

10096
42
Problem 19.3.
Calculate the delta of an at-the-money six-month European call option on a non-dividend-paying
stock when the risk-free interest rate is 10% per annum and the stock price volatility is 25% per
annum.
Answer:
In this case, = , = 0.1, = 0.25 = 0.5 Also,
ln( / )+ (0.1 + 0.2 5 /2)0.5

= = 0.3 712
0.2 5√0.5
The delta of the option is N(d1) or 0.64.
43
Problem 19.4.
What does it mean to assert that the theta of an option position is –0.1 when time is measured
in years? If a trader feels that neither a stock price nor its implied volatility will change, what type
of option position is appropriate?
Answer:
A theta of 01 means that if t units of time pass with no change in either the stock price or its
volatility, the value of the option declines by 01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.
Problem 19.5.
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?
Answer:
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.
Problem 19.6.
“The procedure for creating an option position synthetically is the reverse of the procedure for
hedging the option position.” Explain this statement.
Answer:
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.
Problem 19.7.
Why did portfolio insurance not work well on October 19, 1987?
Answer:
Portfolio insurance involves creating a put option synthetically. It assumes that as soon as a
portfolio’s value declines by a small amount the portfolio manager’s position is rebalanced by
either (a) selling part of the portfolio, or (b) selling index futures. On October 19, 1987, the
market declined so quickly that the sort of rebalancing anticipated in portfolio insurance
schemes could not be accomplished.
44
Problem 19.8.
The Black-Scholes-Merton price of an out-of-the-money call option with an exercise price of $40
is $4. A trader who has written the option plans to use a stop-loss strategy. The trader’s plan is
to buy at $40.10 and to sell at $39.90. Estimate the expected number of times the stock will be
bought or sold.
Answer:
The strategy costs the trader 010 each time the stock is bought or sold. The total expected cost
of the strategy, in present value terms, must be $4. This means that the expected number of
times the stock will be bought or sold is approximately 40. The expected number of times it will
be bought is approximately 20 and the expected number of times it will be sold is also
approximately 20. The buy and sell transactions can take place at any time during the life of the
option. The above numbers are therefore only approximately correct because of the effects of
discounting. Also the estimate is of the number of times the stock is bought or sold in the risk-
neutral world, not the real world.
Problem 19.9.
Suppose that a stock price is currently $20 and that a call option with an exercise price of $25 is
created synthetically using a continually changing position in the stock. Consider the following
two scenarios:
a) Stock price increases steadily from $20 to $35 during the life of the option.
b) Stock price oscillates wildly, ending up at $35.
Which scenario would make the synthetically created option more expensive? Explain your
answer.
Answer:
The holding of the stock at any given time must be N(d1). Hence the stock is bought just after
the price has risen and sold just after the price has fallen. (This is the buy high sell low strategy
referred to in the text.) In the first scenario the stock is continually bought. In second scenario
the stock is bought, sold, bought again, sold again, etc. The final holding is the same in both
scenarios. The buy, sell, buy, sell... situation clearly leads to higher costs than the buy, buy,
buy... situation. This problem emphasizes one disadvantage of creating options synthetically.
Whereas the cost of an option that is purchased is known up front and depends on the
forecasted volatility, the cost of an option that is created synthetically is not known up front and
depends on the volatility actually encountered.
45
Problem 19.10.
What is the delta of a short position in 1,000 European call options on silver futures? The
options mature in eight months, and the futures contract underlying the option matures in nine
months. The current nine-month futures price is $8 per ounce, the exercise price of the options
is $8, the risk-free interest rate is 12% per annum, and the volatility of silver is 18% per annum.
Answer:
The delta of a European futures call option is usually defined as the rate of change of the option
price with respect to the futures price (not the spot price). It is
( )
In this case = 8, = 8, = 0.12, = 0.18, = 0.6667
ln(8/8)+ (0.1 8 /2)× 0.6 667

= = 0.0 735
0.18 √0.6667
( ) = 0.5293 and the delta of the option is
. × .
× 0.5293 = 0.48 86
The delta of a short position in 1,000 futures options is therefore – 488.6.
Problem 19.11.
In Problem 18.10, what initial position in nine-month silver futures is necessary for delta
hedging? If silver itself is used, what is the initial position? If one-year silver futures are used,
what is the initial position? Assume no storage costs for silver.
Answer:
In order to answer this problem, it is important to distinguish between the rate of change of the
option with respect to the futures price and the rate of change of its price with respect to the
spot price.
The former will be referred to as the futures delta; the latter will be referred to as the spot delta.
The futures delta of a nine-month futures contract to buy one ounce of silver is by definition 1.0.
Hence, from the answer to Problem 18.11, a long position in nine-month futures on 488.6
ounces is necessary to hedge the option position.
The spot delta of a nine-month futures contract is . × . = 1.094 assuming no storage costs.
(This is because silver can be treated in the same way as a non-dividend-paying stock when
there are no storage costs. = so that the spot delta is the futures delta times erT) Hence
the spot delta of the option position is – 488.6 x 1.094 = 534.6. Thus a long position in 534.6
ounces of silver is necessary to hedge the option position.
The spot delta of a one-year silver futures contract to buy one ounce of silver is . = 1.1275 .
Hence a long position in . × 534.6 = 474.1 ounces of one-year silver futures is necessary to
hedge the option position.
46
Problem 19.12.
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 give the most favorable result?
a) A virtually constant spot rate

b) Wild movements in the spot rate
Explain your answer.
Answer:
A long position in either a put or a call option has a positive gamma. From Figure 18.8, when
gamma is positive the hedger gains from a large change in the stock price and loses from a
small change in the stock price. Hence the hedger will fare better in case (b).
Problem 19.13.
Repeat Problem 19.12 for a financial institution with a portfolio of short positions in put and call
options on a currency.
Answer:
A short position in either a put or a call option has a negative gamma. From Figure 18.8, when
gamma is negative the hedger gains from a small change in the stock price and loses from a
large change in the stock price. Hence the hedger will fare better in case (a).
Problem 19.14.
A financial institution has just sold 1,000 seven-month European call options on the Japanese
yen. Suppose that the spot exchange rate is 0.80 cent per yen, the exercise price is 0.81 cent
per yen, the risk-free interest rate in the United States is 8% per annum, the risk-free interest
rate in Japan is 5% per annum, and the volatility of the yen is 15% per annum. Calculate the
delta, gamma, vega, theta, and rho of the financial institution’s position. Interpret each number.
Answer:
In this case = . , = . , = . , = . , = . , = .
( . / . ) ( . . . / )× .
= .
= 0.1 016
√ .
= − 0.1 5√0.5833 = − 0.0 130
( ) = 0.5405; ( ) = 0.4998
( )= . × .
The delta of one call option is × 0.5405 = 0.5250
( )= / .
= = 0.3 969.
√ √
47
so that the gamma of one call option is
( ) 0.3 969 × 0.9713

= = 4.2 06
√ 0.80 × 0.15 × √0.5833
The vega of one call option is
√ ( ) = 0.8 0√0.5833 × 0.3 969 × 0.9713 = 0.2355
The theta of one call option is
( ) 0.8 × 0.3969 × 0.15 × 0.9713

− + ( ) − ( )= −
2√ 2√0.5833
+ 0.05 × 0.8 × 0.540 5 × 0.9713 − 0.08 × 0.81 × 0.9544 × 0.4948 = − 0.0399
The rho of one call option is
( )
= 0.8 1 × 0.5833 × 0.9544 × 0.4948
= 0.223 1
Delta can be interpreted as meaning that, when the spot price increases by a small amount
(measured in cents), the value of an option to buy one yen increases by 0.525 times that
amount. Gamma can be interpreted as meaning that, when the spot price increases by a small
amount (measured in cents), the delta increases by 4.206 times that amount. Vega can be
interpreted as meaning that, when the volatility (measured in decimal form) increases by a small
amount, the option’s value increases by 0.2355 times that amount. When volatility increases by
1% (= 0.01) the option price increases by 0.002355. Theta can be interpreted as meaning that,
when a small amount of time (measured in years) passes, the option’s value decreases by
0.0399 times that amount. In particular, when one calendar day passes it decreases by
00399  365  0000109 . Finally, rho can be interpreted as meaning that, when the interest rate
(measured in decimal form) increases by a small amount the option’s value increases by 0.2231
times that amount. When the interest rate increases by 1% (= 0.01), the options value increases
by 0.002231.
48
Problem 19.15.
Under what circumstances is it possible to make a European option on a stock index both
gamma neutral and vega neutral by adding a position in one other European option?
Answer:
Assume that , , , , , , are the parameters for the option held and , ∗ , , , ∗
, are the
parameters for another option. Suppose that d1 has its usual meaning and is calculated on the
basis of the first set of parameters while ∗ is the value of d1 calculated on the basis of the
second set of parameters. Suppose further that w of the second option are held for each of the
first option held. The gamma of the portfolio is:
∗ ∗
( ) ( )
+
√ √ ∗
where α is the number of the first option held.

Since we require gamma to be zero:
( ∗)
( ) ∗
= − ∗
( )
The vega of the portfolio is:
( ) ( ) ∗ ∗ ( ∗)
√ + √ ( )
Since we require vega to be zero:
( ∗)
( )
= − ∗ ∗
( )
Equating the two expressions for w

∗
=
Hence the maturity of the option held must equal the maturity of the option used for hedging.
49
Problem 19.16.
A fund manager has a well-diversified portfolio that mirrors the performance of the S&P 500 and
is worth $360 million. The value of the S&P 500 is 1,200, and the portfolio manager would like to
buy insurance against a reduction of more than 5% in the value of the portfolio over the next six
months. The risk-free interest rate is 6% per annum. The dividend yield on both the portfolio and
the S&P 500 is 3%, and the volatility of the index is 30% per annum.
a) If the fund manager buys traded European put options, how much would the insurance
cost?
b) Explain carefully alternative strategies open to the fund manager involving traded
European call options, and show that they lead to the same result.
c) If the fund manager decides to provide insurance by keeping part of the portfolio in risk-
free securities, what should the initial position be?
d) If the fund manager decides to provide insurance by using nine-month index futures,
what should the initial position be?
Answer:
The fund is worth $300,000 times the value of the index. When the value of the portfolio falls by
5% (to $342 million), the value of the S&P 500 also falls by 5% to 1140. The fund manager
therefore requires European put options on 300,000 times the S&P 500 with exercise price
1140.
a) = , = , = . , = . , = . = . . Hence:
ln(1 200/1140)+ (0.06 − 0.03 + 0.3 /2)× 0.5

= = 0.4 186
0.3 √0.5
= − 0.3 √0.5 = 0.2 064
( ) = 0.6 622; ( ) = 0.5 818

(− ) = 0.3 378; (− ) = 0.4 182
The value of one put option is
1140 ( ) − 1200 (− )
. × . . × .
= 1140 × 0.4 182 − 1200 × 0.3 378
= 63.40
The total cost of the insurance is therefore 300,000 x 63.40 = $19,020,000
50
b) From put–call parity

+ = +
or:
= − +
This shows that a put option can be created by selling (or shorting) e  qT of the index, buying
a call option and investing the remainder at the risk-free rate of interest. Applying this to the
situation under consideration, the fund manager should:
1. Sell 360e-0.03 x 0.5 = $354.64 million of stock

2. Buy call options on 300,000 times the S&P 500 with exercise price 1140 and
maturity in six months.
3. Invest the remaining cash at the risk-free interest rate of 6% per annum.
This strategy gives the same result as buying put options directly.
c) The delta of one put option is

[ ( ) − 1]
. × . (0.66 22 − 1)
=
− 0.3327
This indicates that 33.27% of the portfolio (i.e., $119.77 million) should be initially sold and
invested in risk-free securities.
d) The delta of a nine-month index futures contract is
( ) .03× .
= = 1.023
The spot short position required is
119.770,000
= 99,80 8
1200
times the index. Hence a short position in
99,808
390
1.023 × 250
futures contracts is required.
51
Problem 19.17.
Repeat Problem 19.16 on the assumption that the portfolio has a beta of 1.5. Assume that the
dividend yield on the portfolio is 4% per annum.
Answer:
When the value of the portfolio goes down 5% in six months, the total return from the portfolio,
including dividends, in the six months is
− 5 + 2 = 3%
i.e., - 6% per annum. This is 12% per annum less than the risk-free interest rate. Since the
portfolio has a beta of 1.5 we would expect the market to provide a return of 8% per annum less
than the risk-free interest rate, i.e., we would expect the market to provide a return of – 2% per
annum. Since dividends on the market index are 3% per annum, we would expect the market
index to have dropped at the rate of 5% per annum or 2.5% per six months; i.e., we would
expect the market to have dropped to 1170. A total of 450,000 = (1.5 x 300,000) put options on
the S&P 500 with exercise price 1170 and exercise date in six months are therefore required.
a) = , = , = . , = . , = . = . . Hence
ln(1200/1170)+ (0.06 − 0.03 + 0.09/2)× 0.5

= = 0.2961
0.3 √0.5
= − 0.3√0.5 = 0.084 0
( ) = 0.6164; ( ) = 0.5335
(− ) = 0.383 6; (− ) = 0.466 5
The value of one put option is
(− )− (− )
. × . . × .
= 1170 × 0.4665 − 1200 × 0.3836
= 76.28
The total cost of the insurance is therefore 450,000 x 76.28 = $34,326,000
Note that this is significantly greater than the cost of the insurance in Problem 18.16.
b) As in Problem 18.16 the fund manager can 1) sell $354.64 million of stock, 2) buy call
options on 450,000 times the S&P 500 with exercise price 1170 and exercise date in six
months and 3) invest the remaining cash at the risk-free interest rate.
c) The portfolio is 50% more volatile than the S&P 500. When the insurance is considered
as an option on the portfolio the parameters are as follows: = 360, = 342, = 0.06,
= 0.45, = 0.5 = 0.04
ln(360/342)+ (0.06 − 0.04 + 0.45 /2)× 0.5

= = 0.3517
0.45 √0.5
( ) = 0.6374
52
The delta of the option is

[ ( ) − 1]
. × . (0.63 74 − 1)
=
= − 0.355
This indicates that 35.5% of the portfolio (i.e., $127.8 million) should be sold and invested in
riskless securities.
d) We now return to the situation considered in (a) where put options on the index are
required. The delta of each put option is
( ( )− 1
. × .(0.61 64 − 1)
=
= − 0.3779
The delta of the total position required in put options is – 450,000 x 0.3779 = -170,000. The
delta of a nine-month index futures is (see Problem 19.16) 1.023. Hence a short position in
170,000
= 665
1.023 × 250
index futures contracts.
53
Problem 19.18.
Show by substituting for the various terms in equation (19.4) that the equation is true for:
a) A single European call option on a non-dividend-paying stock

b) A single European put option on a non-dividend-paying stock
c) Any portfolio of European put and call options on a non-dividend-paying stock
Answer:
a) For a call option on a non-dividend-paying stock

∆= ( )
( )
Γ=
√
( )
Θ= − − ( )
2√
Hence the left-hand side of equation (19.4) is:

( ) 1 ( )
= − − ( )+ ( )+
2√ 2 √
= [ ( )− ( )]
= Π
b) For a put option on a non-dividend-paying stock

Δ = ( ) − 1 = (− )
( )
Γ=
√
( )
Θ= − + (− )
2√
Hence the left-hand side of equation (18.4) is:
( ) 1 ( )
− + (− )− (− )+
2√ 2 √
= [ (− )− (− )]
c) For a portfolio of options, , , are the sums of their values for the
individual options in the portfolio. It follows that equation (18.4) is true for any
portfolio of European put and call options.
54
Problem 19.19
What is the equation corresponding to equation (19.4) for (a) a portfolio of derivatives on a
currency and (b) a portfolio of derivatives on a futures contract?
Answer:
A currency is analogous to a stock paying a continuous dividend yield at rate rf. The differential
equation for a portfolio of derivatives dependent on a currency is (see equation 17.6)
Π Π 1 Π
+ − + = Π
2
Hence
1
Θ+ − Δ+ Γ= Π
2
Similarly, for a portfolio of derivatives dependent on a futures price (see equation 18.8)
1
Θ+ Γ= Π
2
55
Problem 19.20.
Suppose that $70 billion of equity assets are the subject of portfolio insurance schemes.
Assume that the schemes are designed to provide insurance against the value of the assets
declining by more than 5% within one year. Making whatever estimates you find necessary, use
the DerivaGem software to calculate the value of the stock or futures contracts that the
administrators of the portfolio insurance schemes will attempt to sell if the market falls by 23% in
a single day.
Answer:
We can regard the position of all portfolio insurers taken together as a single put option. The
three known parameters of the option, before the 23% decline, are = 70, = 66.5, = 1.
Other parameters can be estimated as = 0.06, = 0.25, and = 0.03 . Then:
ln(70/6 6.5)+ (0.06 − 0.03 + 0.25 /2)

= = 0.4 502
0.2 5
( ) = 0.6 737
The delta of the option is

[ ( ) − 1]
.
= (0.6 737 − 1)
= − 0.3167
This shows that 31.67% or $22.17 billion of assets should have been sold before the decline.
These numbers can also be produced from DerivaGem by selecting Underlying Type and Index
and Option Type as Black-Scholes European.
After the decline, = 53.9, = 66.5, = 1, = 0.06, = 0.25and = 0.03 .
ln(5 3.9/66.5)+ (0.06 − 0.03 + 0.25 /2)

= = − 0.5 953
0.2 5
( ) = 0.2758
The delta of the option has dropped to
. × .
(0.2 758 − 1)
= − 0.7028
This shows that cumulatively 70.28% of the assets originally held should be sold. An additional
38.61% of the original portfolio should be sold. The sales measured at pre-crash prices are
about $27.0 billion. At post-crash prices they are about $20.8 billion.
56
Problem 19.21.
Does a forward contract on a stock index have the same delta as the corresponding futures
contract? Explain your answer.
Answer:
With our usual notation the value of a forward contract on the asset is − . When
there is a small change, ∆S, in S0 the value of the forward contract changes by e-qT∆S. The
delta of the forward contract is therefore e-qT. The futures price is S0e(r-q)T. When there is a
small change, ∆S, in S0 the futures price changes by ∆Se(r-q)T. Given the daily settlement
procedures in futures contracts, this is also the immediate change in the wealth of the holder of
the futures contract. The delta of the futures contract is therefore e(r-q)T. We conclude that the
deltas of a futures and forward contract are not the same. The delta of the futures is greater
than the delta of the corresponding forward by a factor of erT.
Problem 19.22.
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?
Answer:
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 x 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 x 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) x 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. As shown in the text (see
Figure 19.8), 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.
57
Problem 19.23.
Use the put–call parity relationship to derive, for a non-dividend-paying stock, the relationship
between:
a) The delta of a European call and the delta of a European put.
b) The gamma of a European call and the gamma of a European put.
c) The vega of a European call and the vega of a European put.
d) The theta of a European call and the theta of a European put.
Answer:
(a) For a non-dividend paying stock, put-call parity gives at a general time t:
( )
+ = +
Differentiating with respect to S:

+ 1=
or
= −1
This shows that the delta of a European put equals the delta of the corresponding
European call less 1.0.
(b) Differentiating with respect to S again
Hence the gamma of a European put equals the gamma of a European call.
c) Differentiating the put-call parity relationship with respect to σ
showing that the vega of a European put equals the vega of a European call.
(d) Differentiating the put-call parity relationship with respect to t
( )
= +
This is in agreement with the thetas of European calls and puts given in Section 19.5 since
( ) = 1 − ( ).
58
Problem 19.24.
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 DerivaGem
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. Use the DerivaGem
Applications Builder functions to plot the option price, delta, gamma, vega, theta, and rho
against the stock price for the stock option.
Answer:
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 x 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 x 0.1 = 0.005 which is 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.
59
Problem 19.25.
A financial institution has the following portfolio of over-the-counter options on sterling:
Type Position Delta of Option Gamma of Option Vega of Option

Call −1,000 0.5 2.2 1.8
Call −500 0.8 0.6 0.2
Put −2,000 -0.40 1.3 0.7
Call −500 0.70 1.8 1.4
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 sterling would make the portfolio both gamma
neutral and delta neutral?
(b) What position in the traded option and in sterling would make the portfolio both vega neutral
and delta neutral?
The delta of the portfolio is

− 1,000 × 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 × 1.3 − 500 × 1.8 = 6,000
The vega of the portfolio is

− 1,000 × 1.8 − 500 × 0.2 − 2,000 × 0.7 − 500 × 1.4 = − 4,000
Answer:
(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 of 1,950 in sterling 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 of 2,550 in sterling is
necessary so that the portfolio is both vega and delta neutral.
60
Problem 19.26.
Consider again the situation in Problem 19.25. 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?
Answer:
Let w1 be the position in the first traded option and w2 be the position in the second traded
option. We require:
6,0 00 = 1.5 + 0.5
4,000 = 0.8 + 0.6
The solution to these equations can easily be seen to be = 3,200, = 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 of 1,710 in sterling.
61
Problem 19.27.
A deposit instrument offered by a bank guarantees that investors will receive a return during a
six-month period that is the greater of (a) zero and (b) 40% of the return provided by a market
index. An investor is planning to put $100,000 in the instrument. Describe the payoff as an
option on the index. Assuming that the risk-free rate of interest is 8% per annum, the dividend
yield on the index is 3% per annum, and the volatility of the index is 25% per annum, is the
product a good deal for the investor?
Answer:
The product provides a six-month return equal to
max(0,0.4R)
where R is the return on the index. Suppose that S0 is the current value of the index and ST is
the value in six months. When an amount A is invested, the return received at the end of six
months is:
−
max 0,0.4
0.4
= max(0, − )
This is 0.4A/S0 of at-the-money European call options on the index. With the usual notation,
they have value:
0.4
[ ( )− ( )]
= 0.4 [ ( )− ( )]
In this case = 0.08, = 0.25, = 0.50and = 0.03
0.08 − 0.03 + 0. 25 /2)0.5 0

= = 0.229 8
0.25 √0.50
= − 0.25√0.50 = 0.0530
( ) = 0.5909; ( ) = 0.5212
The value of the European call options being offered is
. × . . × .
0.4 ( × 0.5 909 − × 0.5 212
= 0.0 325
This is the present value of the payoff from the product. If an investor buys the product, he or
she avoids having to pay 0.0325A at time zero for the underlying option. The cash flows to the
investor are therefore
Time 0: - A + 0.0325A = 0.9675A
After six months: +A
The return with continuous compounding is 2ln(1/0.9675)= 0.066 or 6.6% per annum. The
product is therefore slightly less attractive than a risk-free investment.
62
Problem 19.28.
The formula for the price of a European call futures option in terms of the futures price, F0, is
given as
= [ ( )− ( )]
where
( / )+ /2
=
√
= − √
and K, r, T and σ are the strike price, interest rate, time to maturity, and volatility, respectively.
(a) Prove that ( )= ( )

(b) Prove that the delta of the call price with respect to the futures price is ( ).
(c) Prove that the vega of the call price is √ ( )
(d) Prove the formula for the rho of a call futures option given in Section 19.12. The delta,
gamma, theta, and vega of a call futures option are the same as those for a call option on a
stock paying dividends at rate q with q replaced by r and S0 replaced by F0. Explain why the
same is not true of the rho of a call futures option.
Answers:
(a)
( )= /
√2
√ /
( )= − √ =
√2
Because √ = ln( / )+ /2 the second equation reduces to
( ) ( / ) ( / ) /
= =
√2 √2
63
The result follows.
(b)
= ( )+ ( ) − ( )
Because
=
it follows from the result in (a) that
= ( )
(c)
= ( ) − ( )
Because = + √
= +√
From the result in (a) it follows that

= ( )√
(d)
Rho is given by
= − [ ( )− ( )]
or -cT. Because q = r in the case of a futures option there are two components to rho.
One arises from differentiation with respect to r, the other from differentiation with
respect to q.
64
Problem 19.29.
Use DerivaGem to check that equation (19.4) is satisfied for the option considered in Section
19.1. (Note: DerivaGem produces a value of theta “per calendar day.” The theta in equation
(19.4) is “per year.”)
Answer:
For the option considered in Section 19.1, = 49, = 50, = 0.05, = 0.20 =
0.20/52. DerivaGem shows that Θ = − 0.011795× 365 = − 4.305, ∆= 0.5216, Γ = 0.065544,
Π = 2.4005. The left hand side of equation (19.4)
1
− 4.305 + 0.05 × 49 × 0.5216 + × 0.2 × 49 × 0.065 544 = 0.120
2
The right hand side is 0.05 × 2.4005 = 0.120
This shows that the result in equation (19.4) is satisfied.
65
Problem 19.30. (Excel file)

Use the DerivaGem Application Builder functions to reproduce Table 19.2. (Note that in Table
19.2 the stock position is rounded to the nearest 100 shares.) Calculate the gamma and theta of
the position each week. Calculate the change in the value of the portfolio each week and check
whether equation (19.3) is approximately satisfied. (Note: DerivaGem produces a value of theta
“per calendar day.” The theta in equation (19.3) is “per year.”)
Answer:
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
changes from 52,200 x 49 = $2,557,800 to 52,200 x 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 -
6554.4 and 430,533 so that equation (19.3) predicts the gain as
1 1
430533× − × 6554.4 × (48.12 − 49 ) = 5742
52 2
The results for all 20 weeks are shown in the following table.
Week Actual Gain Predicted Gain

1 5,357 5,742
2 5,689 6,093
3 −19,742 −21,084
4 1,941 1,572
5 3,706 3,652
6 9,320 9,191
7 6,249 5,936
8 9,491 9,259
9 961 870
10 −23,380 −18,992
11 1,643 2,497
12 2,645 1,356
13 11,365 10,923
14 −2,876 −3,342
15 12,936 12,302
16 7,566 8,815
17 −3,880 −2,763
18 6,764 6,899
19 4,295 5,205
20 4,806 4,805
66

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P1.T4. Valuation & Risk Models

Chapter 16. Option Sensitivity Measures: The

Bionic Turtle FRM Practice Questions

Chapter 16. Option Sensitivity Measures: The “Greeks”

Hull: Options, Futures & Other Derivatives – Chapter 19 Q&A

Chapter 16. Option Sensitivity Measures: The “Greeks”

Hull’s Textbook Q&A

P1.T4.817. Option delta

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-817-option-delta-hull-

P1.T4.818. Futures delta and dynamic delta hedging

 d1 = [LN(3.30/3.00) + (0.20^2/2)*0.25] / 0.20*sqrt(0.250) = 1.003102 or approximately

Position Δ = 1,000 * N(d1)*exp(-rT) = 1,000*N(1)*exp(-0.040*.25) = -1,000 * 0.841345 * exp(-

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-818-futures-delta-

P1.T4.819. Theta, gamma and vega for option positions

a) Loss of about $337.00

819.2. C. True: +8,400

819.3. A. True: Loss of $16,750.00.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-819-theta-gamma-

P1.T4.820. Delta- and gamma-neutral position; and the relationship

820.1. C. True: $29,135

The delta-gamma approximated change is given by ΔS*Δ+ 0.5*Γ*(ΔS)^2; in this case of ΔS = +

We need to solve for two variables in two equations, as follows:

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-820-delta-and-

P1.T4.821. Delta hedging, scenario analysis and portfolio insurance

In which quadrant is the greatest potential LOSS to Ozerholding located?

a) Short 43 index futures contracts

821.3. A. True: Short 43 index futures contracts

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t4-821-delta-hedging-

P1.T4.400. Option delta

Which of the above statements is (are) TRUE?

a) None are true

Which trade will make the portfolio delta neutral?

a) Short 1,800 shares

400.2. D. All are true

In regard to III and IV,

400.3. A. Short 1,800 shares

Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-400-option-delta.7651/

P1.T4.401. Option gamma

401.2. A. It is a normal probability density function (pdf).

Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-401-option-gamma.7665/

P1.T4.402. Option vega

Which is nearest to the option's vega?

a) Vega tends to increase with option maturity

402.2. C. 19.33 = (6.99 - 6.41)/(0.33 - 0.30)

In regard to (A), (B) and (D), each is TRUE.

Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-402-option-vega.7672/

P1.T4.403. Option theta

Note the exact, analytical theta at three years is -4.422 years.

403.2. C. $14.28. $14.90 - ($15.50 * 10/250) = $14.28 (actual price is $14.2725)

In regard to (A), (C) and (D), each is TRUE.

Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-403-option-theta.7686/

P1.T4.404. Neutralizing option position Greeks

404.1. B. Short 160 of the underlying shares

Discuss at: https://www.bionicturtle.com/forum/threads/p1-t4-404-neutralizing-option-position-

P1.T4.6. Option delta

6.1. D. 0.58 (ATM call) and -0.42 (ATM put)

6.2. B. Short 382 shares

6.6. d. ITM put, OTM put, OTM call, ITM call

Discuss in forum here: http://www.bionicturtle.com/forum/threads/p1-t4-6-option-delta.4829/

P1.T4.7. Dynamic delta hedging

7.1. B. Sell 3.0 shares

 d1 = [LN(3.30/3.00) + (0.20^2/2)0.25] / 0.20sqrt(0.250) = 1.003102 or approximately

Position Δ = 1,000 * N(d1)exp(-rT) = 1,000N(1)exp(-0.040.25) = -1,000 * 0.841345 * exp(-

The delta-gamma approximated change is given by ΔSΔ+ 0.5Γ*(ΔS)^2; in this case of ΔS = +

Per Hull: Theta + (Rf * S * delta) + (0.5variance(S)S^2Gamma) = RfValue(option portfolio),