A stock price is currently $20 In 3 months it will be either $22 or $18

Stock Price = $22 Stock price = $20 Stock Price = $18

A 3-month call option on the stock has a strike price of 21.

Stock Price = $22 Option Price = $1
Stock price = $20 Option Price=? Stock Price = $18 Option Price = $0

Consider the Portfolio: long D shares short 1 call option

22D 1

Portfolio is riskless when 22D 1 = 18D or

D = 0.25

18D

The riskless portfolio is: long 0.25 shares short 1 call option The value of the portfolio in 3 months is 22 0.25 1 = 4.50 The value of the portfolio today is 4.5e 0.120.25 = 4.3670

The portfolio that is long 0.25 shares short 1 option is worth 4.367 The value of the shares is 5.000 (= 0.25 20 ) The value of the option is therefore 0.633 (= 5.000 4.367 )

c S 0 N (d1 ) K e rT N (d 2 ) p K e rT N (d 2 ) S 0 N (d1 ) 2 / 2)T ln( S 0 / K ) (r where d1 T ln( S 0 / K ) (r 2 / 2)T d2 d1 T T

A bank has sold for `300,000 a European call option on 100,000 shares of a non-dividend paying stock S0 = 49, K = 50, r = 5%, = 20%, T = 20 weeks, m = 13% The Black-Scholes value of the option is ` 240,000 How does the bank hedge its risk to lock in a ` 60,000 profit?

Naked position Take no action Covered position Buy 100,000 shares today Both strategies leave the bank exposed to significant risk

This involves: Buying 100,000 shares as soon as price reaches ` 50 Selling 100,000 shares as soon as price falls below ` 50 This deceptively simple hedging strategy does not work well

Delta (D) is the rate of change of the option price with respect to the underlying

Option price Slope = D A

Stock price

This involves maintaining a delta neutral portfolio The delta of a European call on a nondividend paying stock is N (d 1) The delta of a European put on the stock is N (d 1) 1

The hedge position must be frequently rebalanced Delta hedging a written option involves a buy high, sell low trading rule

Theta (Q) of a derivative (or portfolio of derivatives) is the rate of change of the value with respect to the passage of time The theta of a call or put is usually negative. This means that, if time passes with the price of the underlying asset and its volatility remaining the same, the value of a long option declines

When we are hedging we take positions that offset D, G, n, etc. When we create an option synthetically we take positions that match D, G, & n

Gamma (G) is the rate of change of delta (D) with respect to the price of the underlying asset Gamma is greatest for options that are close to the money (At the Money)

Call price
C'' C'

Stock price S S'

Vega (n) is the rate of change of the value of a derivatives portfolio with respect to volatility Vega tends to be greatest for options that are close to the money (At the Money)

D can be changed by taking a position in the underlying To adjust G & n it is necessary to take a position in an option or other derivative

Rho is the rate of change of the value of a derivative with respect to the interest rate For currency options there are 2 rhos

Sensitivity Factor (Greek)

Delta

Input

Calls

Puts

Asset price (S)

Positively related (Delta> 0) Positively related (Vega> 0) Positively related (Rho> 0) Value 0 as call maturity (Theta< 0) Negatively related

Negatively related ( Delta< 0) Positively related (Vega> 0) Negatively related (Rho< 0) Value 0 as put maturity (Theta <0) Positively related

Vega

Volatility (s)

Rho

Risk-free rare (r)

Theta

Time to expiration

Exercise price (X)