The Greek

Letters
 ILLUSTRATION
 The financial institution has sold for $300,000 a
European call option on 100,000 shares of a non-
dividend-paying stock.
 S0 = 49, K = 50, r = 5%, σ= 20%, T = 20 weeks
(0.3846 years), μ=13%
 The Black-Scholes price of the option is about
$240,000.
 The financial institution has therefore sold the option
for $60,000 more than its theoretical value, but it’s
faced with the problem of hedging the risk.
 NAKED & COVERED
POSITIONS
 Naked Position
　　 One strategy open to the financial institut
ion is to do nothing.
 Covered Position

　　 Buying 100,000 shares as soon as the o

ption has been sold.
 Neither a naked position nor a covered posit

ion provides a good hedge.

A STOP-LOSS STRATEGY
DELTA HEDGING

 Delta () is the rate of change of the option

price with respect to the underlying asset.
c

S
 c is the price of the call option.
 S is the stock price
DELTA HEDGING
 DELTA HEDGING

 For a European call option on a non-dividend-

paying stock

(call )  N (d1 )
 For a European put option on a non-dividend-
paying stock

( put )  N (d1 ) - 1
DELTA HEDGING
DELTA HEDGING
 DELTA HEDGING

 Π is the value of the portfolio
S
 The delta of a portfolio of options or other derivat
ives dependent on a single asset whose price is
S. n
   wi  i
i 1
 A portfolio consists of a quantity wi of option i (1
≦i≦n)
 Δi is the delta of the ith option.
 THETA

 The theta () of a portfolio of options is the

rate of change of the value of the portfolio
with respect to the passage of time with all
else remaining the same.
 Theta is sometimes referred to as the time
decay of the portfolio.
 THETA
S 0 N ' (d1 )
(call )  - - rKe - rT N (d 2 )
2 T

1 - x2 / 2
N ( x) 
'
e
2

S 0 N ' (d1 )
( put )  -  rKe - rT N (- d 2 )
2 T
 Because N(-d2)=1-N(d2), the theta of a put excee
ds the theta of the corresponding call by rKe-rT
THETA
THETA
 GAMMA

 The gamma () is the rate of change of the

portfolio’s delta () with respect to the price
of the underlying asset.

  2

S 2
GAMMA
 GAMMA
 Making a portfolio gamma neutral
wT T  
 A delta-neutral portfolio has a gamma equal to Γ
 A traded option has a gamma equal to ΓT
 The number of traded options added to the portfol
io is wT
 Calculation of Gamma
N ' (d1 )

S 0 T
GAMMA
GAMMA
RELATIONSHIP BETWEEN
DELTA, THETA, AND GAMMA
f f 1 2 2  f2
 rS   S  rf
t S 2 S 2

  1 2 2  2 
 rS   S  r
t S 2 S 2

   2
  
t S S 2

1 2 2 1 2 2
  rS   S   r    S   r
2 2
 VEGA

 The vega () is the rate of change of the va

lue of a derivatives portfolio with respect to
volatility of the volatility of the underlying a
sset.


 

 VEGA
 For a European call or put option on a non-
dividend-paying stock   S 0 T N ' (d1 )
 RHO
 The rho(ρ) of a portfolio of options is the rate of change
of the value of the portfolio with respect to the interest ra
te. 

r
 It measures the sensitivity of the value of a portfolio to a
change in the interest rate when all else remains the sa
me.
 (call )  KTe - rT N (d 2 )
 ( put )  - KTe - rT N (- d 2 )
 THE REALITIES OF
HEDGING
 When managing a large portfolio dependent on a
single underlying asset, traders usually make del
ta zero, or close to zero, at least once a day by tr
ading the underlying asset.

 Unfortunately, a zero gamma and a zero vega ar

e less easy to achieve because it is difficult to fin
d options or other nonlinear derivatives that can
be traded in the volume required at competitive p
rices.
 SCENARIO ANALYSIS
 The analysis involves calculating the gain or less
on their portfolio over a specified period under a
variety of different scenarios.

 The time period chosen is likely to depend on

the liquidity of the instruments.

 The scenarios can be either chosen by

management or generated by a model.
EXTENSION OF FORMULAS
Delta of Forward Contracts
 EXTENSION OF FORMULAS
Delta of Futures Contracts
 The underlying asset is a non-dividend-paying stock
HF=e-rTHA
 The underlying asset pays a dividend yield q
HF=e-(r-q)THA
 A stock index, q: the divided yield on the index
 A currency, q: the foreign risk-free rate, rf
HF=e-(r-rf)THA
 T: Maturity of futures contract
 HA: Required position in asset for delta hedging
 HF: Alternative required position in futures contracts for
delta hedging
 PORTFOLIO INSURANCE
 A portfolio manager is often interested in acquiring a put
option on his or her portfolio.
 The provides protection against market declines while
preserving the potential for a gain if the market does
well.
 Options markets don’t always have the liquidity to
absorb the trades required by managers of large funds.
 Fund managers often require strike prices and exercise
dates that are different from those available in
exchange-traded options markets.
 PORTFOLIO INSURANCE
Use of Index
 Futures
The dollar amount of the futures contracts shorted as a
proportion of the value of the portfolio

e - qT e - ( r - q )T * [1 - N (d1 )]  e q (T *-T ) e - rT * [1 - N (d1 )]

 The portfolio is worth A1 times the index
 Each index futures contract is on A2 times the index
 The number of futures contracts shorted at any given
time
e q (T *-T ) e - rT * [1 - N (d1 )] A1 / A2
 STOCK MARKET
VOLATILITY
 Portfolio insurance strategies such as those just
described have the potential to increase
volatility.
 When the market declines, they cause portfolio
managers either to sell stock or to sell index
futures contracts.
 When the market rises, the portfolio insurance
strategies cause portfolio managers either to buy
stock or to buy futures contracts.
 STOCK MARKET
VOLATILITY
 Whether portfolio insurance trading strategies
(formal or informal) affect volatility depends on
how easily the market can absorb the trades that
are generated by portfolio insurance.
 If portfolio insurance trades are a very small
fraction of all trades, there is likely to be no
effect.
 As portfolio insurance becomes more popular, it
is liable to have a destabilizing effect on the
market.
SUMMARY

European European American American

Variable
call put call put

�

�S
＋ － ＋ －

�
q ？ ？ ＋ ＋
�T

�
 ＋ ＋ ＋ ＋

�
�
 ＋ － ＋ －
�r
＋： Indicates that an increase in the variable causes the option price to increase
－： Indicates that an increase in the variable causes the option price to decrease
？： Indicates that the relationship is uncertain