1. 14-0 Finance 457 14 Chapter Fourteen The Greek Letters

2. 14-1 Finance 457 Executive Summary This chapter covers the way in which traders working for financial institutions and market makers on the floor of an exchange hedge a portfolio of derivatives. The software, DerivaGem for Excel, can be used to chart the relationships between any of the Greek letters and variables such as S 0, K, r,  and T.

3. 14-2 Finance 457 Chapter Outline 14.1 Illustration 14.2 Naked and Covered Positions 14.3 A Stop-Loss Strategy 14.4 Delta Hedging 14.5 Theta 14.6 Gamma 14.7 Relationship Between Delta, Theta, and Gamma 14.8 Vega 14.9 Rho 14.10 Hedging in Practice 14.11 Scenario Analysis 14.12 Portfolio Insurance 14.13 Stock Market Volatility

4. 14-3 Finance 457 14.1 Illustration A bank has sold for $300,000 a European call option on 100,000 shares of a non-dividend paying stock S 0 = $49, K = $50, r = 5%,  = 20%, T = 20 weeks,  = 13% The Black-Scholes value of the option is around $240,000 How does the bank hedge its risk to lock in a $60,000 profit?

5. 14-4 Finance 457 14.2 Naked and Covered Positions Naked position Take no action: wait for expiry and “hope for the best” Covered position Buy 100,000 shares today this amounts to a covered call position Both strategies leave the bank exposed to significant risk.

6. 14-5 Finance 457 14.2 Naked and Covered Positions Neither a naked position nor a covered position provides a satisfactory hedge. Put-call parity shows that the exposure from writing a covered call is the same as the exposure from writing a naked put. For a perfect hedge the standard deviation of the cost of writing and hedging the option is zero.

7. 14-6 Finance 457 14.3 A Stop-Loss Strategy 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 in practice: Purchases and subsequent sales cannot be made at K. Transactions costs could easily eat the option premium and then some.

8. 14-7 Finance 457 14.4 Delta Hedging Most traders use more sophisticated hedging schemes. These involve calculating measures such as delta, gamma, and vega. Delta was introduced in Chapter 10 Delta is very closely related to the idea of the replicating portfolio intuition.

9. 14-8 Finance 457 Delta (See Figure 14.2, page 302) Delta (  ) is the rate of change of the option price with respect to the underlying security If you have a pricing equation, just take a derivative with respect to S Option price A B Slope =  Stock price

10. 14-9 Finance 457 Delta Hedging This involves maintaining a delta neutral portfolio 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]

11. 14-10 Finance 457 Variation of Delta with Stock Price Stock price  of call Stock price  of put +1 KK

12. 14-11 Finance 457 Delta Hedging The hedge position must be frequently rebalanced Delta hedging a written option involves a “buy high, sell low” trading rule See Tables 14.2 (page 307) and 14.3 (page 308) for examples of delta hedging

13. 14-12 Finance 457 Using Futures for Delta Hedging The delta of a futures contract is e (r-q)T times the delta of a spot contract The position required in futures for delta hedging is therefore e -(r-q)T times the position required in the corresponding spot contract

14. 14-13 Finance 457 Transactions costs Maintaining a delta-neutral position in a single option and the underlying assets is likely to be prohibitively expensive due to transactions costs. However, for a large portfolio of options, delta hedging is much more feasible: –Only 1 trade in the underlying assets is necessary to zero out delta for the whole portfolio. –The transactions costs of delta hedging could then be spread over many different trades.

15. 14-14 Finance 457 14.5 Theta Theta (  ) of a derivative (or portfolio of derivatives) is the rate of change of the value with respect to the passage of time See Figure 14.5 for the variation of  with respect to the stock price for a European call

16. 14-15 Finance 457 14.6 Gamma Gamma (  ) is the rate of change of delta (  ) with respect to the price of the underlying asset See Figure 14.9 for the variation of  with respect to the stock price for a call or put option

17. 14-16 Finance 457 Gamma Addresses Delta Hedging Errors Caused By Curvature (Figure 14.7, page 312) S C Stock price S’S’ Call price C’ C’’

18. 14-17 Finance 457 Interpretation of Gamma For a delta neutral portfolio,     t + ½  S 2  SS Negative Gamma  SS Positive Gamma

19. 14-18 Finance 457 14.7 Relationship Between , and  Delta (  ) is the rate of change of the option price with respect to the underlying security Gamma (  ) is the rate of change of delta (  ) with respect to the price of the underlying asset Theta (  ) of a derivative (or portfolio of derivatives) is the rate of change of the value with respect to the passage of time

20. 14-19 Finance 457 14.7 Relationship Between , and  The price of a single derivative dependent on a non- dividend paying stock must satisfy the Black-Scholes- Merton differential equation:

21. 14-20 Finance 457 14.7 Relationship Between , and  For a portfolio of derivatives on a stock paying a continuous dividend yield at rate q

22. 14-21 Finance 457 14.8 Vega Vega ( ) is the rate of change of the value of a derivatives portfolio with respect to volatility See Figure 14.11 for the variation of with respect to the stock price for a call or put option

23. 14-22 Finance 457 Managing Delta, Gamma, & Vega  can be changed by taking a position in the underlying To adjust  & it is necessary to take a position in an option or other derivative

24. 14-23 Finance 457 14.9 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

25. 14-24 Finance 457 14.10 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 a portfolio becomes larger hedging becomes less expensive

26. 14-25 Finance 457 Hedging vs. Creation of a Synthetic Option When we are hedging we take positions that offset , ,, etc. When we create an option synthetically we take positions that match  & 

27. 14-26 Finance 457 14.11 Scenario Analysis A scenario analysis involves testing the effect on the value of a portfolio of different assumptions concerning asset prices and their volatilities

28. 14-27 Finance 457 14.12 Portfolio Insurance It is essential to understand what portfolio insurance is: Portfolio insurance involves creating a long position in an option synthetically.

29. 14-28 Finance 457 Portfolio Insurance In October of 1987 many portfolio managers attempted to create a put option on a portfolio synthetically This involves initially selling enough of the portfolio (or of index futures) to match the  of the put option

30. 14-29 Finance 457 Portfolio Insurance As the value of the portfolio increases, the  of the put becomes less negative and some of the original portfolio is repurchased As the value of the portfolio decreases, the  of the put becomes more negative and more of the portfolio must be sold

31. 14-30 Finance 457 Portfolio Insurance The strategy did not work well on October 19, 1987...

32. 14-31 Finance 457 14.13 Stock Market Volatility Trading itself is a cause of volatility. Portfolio insurance schemes such as those just described have the potential to increase volatility. When the market declines, they cause portfolio managers to either sell stock or to sell index futures contracts. Either action may accentuate the decline. Selling obviously carries the potential to drive down prices The sale of index futures contracts is liable to drive down futures prices, this creates selling pressure on stocks via the index arbitrage mechanism. Whether the portfolio insurance schemes affect volatility depends on how easily the market can absorb the trades that are generated by portfolio insurance. Widespread use of portfolio insurance could have a destabilizing effect on the market—which would of course increase the necessity of portfolio insurance.

33. 14-32 Finance 457 Summary Delta (  ) is the rate of change of the option price with respect to the underlying security Gamma (  ) is the rate of change of delta (  ) with respect to the price of the underlying asset Theta (  ) of a derivative (or portfolio of derivatives) is the rate of change of the value with respect to the passage of time

34. 14-33 Finance 457 Summary Vega ( ) is the rate of change of the option price with respect to the volatility of the underlying security Rho (  ) of a derivative (or portfolio of derivatives) is the rate of change of the value with respect to the interest rate