RISK MANAGEMENT

Lecture 12

Greek Letters

Greek Letters

A FI is exposed to various kinds of risk when it sells an option in the OTC market. Greeks indicate the sensitivity of option price changes to changes in the parameters of option price like:

Stock price Strike price Time to expiration Volatility Risk free rate

Greek Letters

Each Greek Letter measures a different dimension to the risk in an option. The aim of a trader is to manage the Greeks so that all risks are acceptable.

Example

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%, s = 20%, T = 20 weeks, m = 13% The Black-Scholes value of the option is $240,000. This means that bank has made an upfront profit of $60,000. But it faces certain risks. How does the bank hedge its risk?

Strategies

Do nothing:

Naked position : works well if option is not exercised. Buy 100,000 shares as soon as option is sold. Works well if option is exercised.

Else adopt a Covered Position:

Both strategies leave the bank exposed to significant risk.

Stop-Loss Strategy

Stop-loss strategy involves: Buying 100,000 shares as soon as price reaches $50. Selling 100,000 shares as soon as price falls below $50. The scheme is designed to ensure that FI owns the stock if option is in the money and does not own it if option closes out of money. This deceptively simple hedging strategy does not work well because:

Cash flows occur at different times & must be discounted. Purchases & sales cannot be made at same strike price X.

Delta Hedging Strategy

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

Option price Slope = D A

Stock price

Delta Hedging

If delta of an option is 0.8 it means that when stock price changes by a small amount the option price changes by 80% of that amount. Delta hedging involves maintaining a delta neutral portfolio.

Covered Call:

Buy one stock for each call option sold. Stock price increases: Value of stock in the portfolio goes up but the increase in value of call option reduces the value of the portfolio (Why?). Perfect hedge: Loss on one position is exactly offset by gain on other position.

The hedge position must be frequently rebalanced.

Increases the transaction costs.

Delta Hedging

Delta of a call option is always positive.

Delta of a call option on non-dividend paying stock = N (d 1)

Delta of a put option is always negative.

Delta of a put option on non-dividend paying stock = N (d 1) 1

The delta of a European call on a stock paying dividends at rate q is N (d 1)e qT The delta of a European put is e qT [N (d 1) 1]. These formulas can be modified for stock indices, foreign currency or a futures contract.

Delta Hedging Using Futures

Delta Hedging requires a position in the underlying asset.

This requires initial investment and entails transaction costs.

This problem can be avoided by using futures contracts on underlying asset. The delta of a futures contract is erT times the delta of a spot contract. The position required in futures for delta hedging is therefore e-rT times the position required in the corresponding spot contract.

Delta of Portfolio
Delta of a portfolio can be calculated from deltas of individual options in the portfolio.

Weighted average of options in the portfolio.

Delta neutrality is cheaper for portfolio of options.

Gamma

Gamma (G) is the rate of change of delta (D) with respect to the price of the underlying asset. If gamma is small delta changes slowly and adjustments need to be made infrequently. If gamma is large, delta is highly sensitive to changes in stock prices and needs to be rebalanced frequently.

Gamma Addresses Delta Hedging Errors Caused By Curvature

Call price
C C C

Stock price S S

Gamma Neutrality

A position in asset or a forward contract on it cannot be used to change gamma of a portfolio. Gamma neutrality is achieved by a position in an option. If GT is the gamma of a traded option then the position required to make portfolio gamma neutral is -G/ GT.. When this is done delta of portfolio changes which again needs to be rebalanced.

Theta

Theta (Q) of a derivative (or portfolio of derivatives) is the rate of change of the value with respect to the time to maturity. Time Decay of the option. Value of theta is negative for an option.

Vega

Volatility is assumed to be constant during the life of the option.

In reality it is not constant.

Vega (n) is the rate of change of the value of a derivatives portfolio with respect to volatility of the underlying asset. If vega is high, portfolio value is very sensitive to small changes in volatility.

Managing Delta, Gamma, & Vega

Delta, D, can be changed by taking a position in the underlying asset. To adjust gamma, G, and vega, n, it is necessary to take positions in two options.

Rho

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.

Hedging in Practice

Traders usually ensure that their portfolios are delta-neutral at least once a day. Whenever the opportunity arises, they improve gamma and vega. As portfolio becomes larger hedging becomes less expensive.

Creation of an Option Synthetically

Portfolio value can be protected by using a protective put strategy. Instead of buying an option to hedge a position a portfolio manager may create an option synthetically. Managers often require strike prices and dates that are not available. Markets lack liquidity to absorb the trades. This involves creating a position in the underlying asset so that delta of the position is equal to delta of required position. The position necessary to create an option is reverse of that necessary to hedge it.

Portfolio Insurance

This involves initially selling enough of the portfolio (or of index futures) to match the D of the put option. Delta of a put is e qT [N (d 1) 1].
Therefore to create a put synthetically the fund manager should ensure that e qT [1- N (d 1)] stocks have been sold and the proceeds are invested in risk-less assets.

Portfolio Insurance

As the value of the portfolio increases, the D of the put becomes less negative and some of the original portfolio is repurchased. As the value of the portfolio decreases, the D of the put becomes more negative and more of the portfolio must be sold. Both these tend to accentuate market increases and decreases.