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Hedging of Financial Derivatives and Portfolio

Insurance

Gasper Godson Mwanga


African Institute for Mathematical Sciences
6, Melrose Road, 7945 Muizenberg, Cape Town
South Africa.
e-mail: gasper@aims.ac.za, gmlangwe@yahoo.co.uk

Supervisor : Prof. J. C. Ndogmo


Department of Mathematical
University of Western Cape
Private Bag X17, 7535 Bellville, Capetown
South Africa

June 25, 2005


Contents

List of Figures iii

Acknowledgements iv

1 Introduction 1

1.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.2 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.3 Derivative security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.3.1 Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.3.2 Forwards and Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.3.3 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.4 Important Formulae . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2 The Greek Letters 6

2.1 Naked and Covered Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2.2 Stop-Loss Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.3 Delta Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

2.3.1 Hedging Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2.3.2 Delta of Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.4 Delta of European Calls and Puts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.4.1 Delta of Other European Options . . . . . . . . . . . . . . . . . . . . . . . . . 12

2.5 Theta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

2.6 Gamma Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14


CONTENTS ii

2.6.1 Making a Portfolio Gamma-Neutral . . . . . . . . . . . . . . . . . . . . . . . 15

2.6.2 Calculation of Gamma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

2.6.3 Relationship between ∆, Θ & Γ . . . . . . . . . . . . . . . . . . . . . . . . . . 16

2.7 Rho (ρ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.8 Vega (V) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

2.8.1 Calculation of Vega . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2.9 Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

3 Portfolio Insurance 23

3.1 Preliminary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

3.2 Using Index Options for Portfolio Insurance . . . . . . . . . . . . . . . . . . . . . . . 24

3.3 Creating Options Synthetically . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

3.3.1 Use of the Trading of Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . 25

3.3.2 Use of Index Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Conclusion 28

A Determination of Delta for a European call Option 29

B Determination of Theta for a European call Option 31

Bibliography 32
List of Figures

2.1 Stop-Loss strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

2.2 Calculation of delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2.3 Theta of European call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

2.4 Gamma of European options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

2.5 Rho of European call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

2.6 Vega of European options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21


Acknowledgements

I am indebted to many people from the early stages to the final write up of this work for their help,
ideas and suggestions. My greatest debt is to my supervisor, Prof. J. C. Ndogmo for his assistance
and encouragement during the preparation of this work. I would be wrong if I will not acknowledge
Dr. M. Pickles, Prof. W. Kotze, L. Wills and my fellow students, for their assistance in correcting
and editing this work.

Finally, I want to acknowledge all the AIMS staff, in particular Prof. F. Hahne, Prof. N. G. Turok
as well as all the sponsors of the AIMS programme for making my stay in AIMS such a wonderful
experience. I will not regret my decision of coming to AIMS, because I learnt a lot in the courses
offered and also I interacted with world renowned academics.
To my parents
Abstract

Risk management is an important issue in finance because of the considerable impact of the volatil-
ity of asset prices on financial holdings. Investment banks, financial corporations and insurance
companies around the globe are searching for techniques to enhance their risk management prac-
tices. Because of the rapid development of derivative markets, this practice becomes more complex
and challenging. This accelerates the development of more advanced techniques in risk manage-
ment and creates many interesting theoretical and practical problems for researchers. Hedging is
the trading strategy which attempts to reduce the degree of risk exposure. In this essay we analyse
some common hedging strategies such as naked and covered positions, stop-loss strategies and show
how more specific hedging strategies denoted by Greek letters, namely delta, gamma, theta, Vega,
and rho can be used to improve the hedging performance. The relationship among these Greek
letters and the way in which each affects the change in the portfolio value will also be discussed,
as well as scenario analysis and portfolio insurance.

2005 Mathematics Subject Classification codes 62PXX, 62P20, 91BXX, 91B30


Chapter 1

Introduction

This chapter will highlight the main concepts we will discuss in the subsequent chapters.

1.1 Background

The option pricing theories we are familiar with nowadays has strong roots in stochastic calculus.
This concept traces back as far as 1877, when Charles Castelli wrote a book called The Theory of
Options in Stock and Shares. This book introduced the concepts of hedging and speculation. Also
the financial mathematician Louis Bachelier in 1900 wrote his thesis Théorie de la Spéculation.
In this paper he discussed the analysis of the stock and option markets and it also contains some
ideas in the theory of Brownian motion. Five years later in 1905 A. Einstein wrote a famous
paper on Brownian motion which we use for the mathematical modeling of price movements and
the evaluation of contingent claims in financial markets [6].

In 1973, Fisher Black and Myron Scholes published their ground breaking paper The Pricing
of Options and Corporate Liabilities in the Journal of Political Economy. This work gained its
recognition when in 1997, Robert Merton and Myron Scholes were given the Nobel prize. Part of
this work exposes the issue of hedging which we will discuss in this essay [10].

Most scholars continue to criticise the assumptions underlying the Black-Scholes model which led
to much research in this area which give rise to more advances the models. The work of H. E.
Leland titled Option pricing and replication with Transaction costs published in the Journal of
Finance 1985, tries to rectify the trap of the Black-Scholes assumption of no transaction q cost; it
introduces the type of hedging strategy depending on the value of Leland number A = π2 . √k ,
σ δt
where k is the round-trip transaction cost, σ is the volatility of the underlying asset and δt is the
time-lag between transactions. When A < 1 the Black-Scholes delta-hedging is valid [9].
1.2 Markets 2

1.2 Markets

In financial markets the traded item may be an asset (basic equity) such as a stock, bond, or a
unit of currency. The item’s value may be directly derived from the value of some other traded
asset. If so, its future price is tied to the price of another asset. In this case the item is a financial
derivative; the asset it refers to is called the underlying asset. A collection of assets all owned by
the same individual or organisation is called a portfolio. The person or firm who formulates the
contract and offers it for sale is termed as the writer, while a person or firm who purchases the
contract is called the holder.

The value of a portfolio made up of underlying assets is simply a linear combination of their prices.
To see this let the market have d + 1 assets labelled S0 , S1 , . . . Sd , where we assume that the first
is riskless, so that its price S0 (0) determines its price S0 (t) at future time t with certainty. Then,
other assets are risky, so that their prices Si (t), i = 1, 2, . . . , d are random variables. We usually
refer to the risky assets as stocks. Clearly the value at any future time t of a portfolio containing
θi assets is given by
Xd
Vt (θ) = θi Si (t).
i=0

This linearity of portfolio prices allows us to price other assets in terms of the underlying ones
provided we are able to construct a notional portfolio whose value at all times is the same as that
of the asset we seek to price. This is the fundamental idea underpinning hedging strategies, which
is the key concept in modelling a financial market.

In financial markets there are three major types of trading participants. Together they provide
important liquidity to facilitate entry into and exit from the market. These traders are as follows:

1. Hedgers
These are traders who want to avoid risk exposure due to the price movements of an asset.
They do this by taking a position in an option or forward contract and use hedging strategies.

2. Speculators
Speculators make profit from predicting directional changes in price in the market. If they
are betting that price will go up, they can for example take a long position in a call option
because the asset will have a higher price in future and if they are betting that price will go
down, they may take a short position in call option (see this in discussion of options). If they
are successful they make a profit, if not they incur losses.

3. Arbitrageurs
Arbitrageurs take advantage of price discrepancies between the underlying market and the
derivatives market with the intention of making a profit, by buying in the cheaper market and
selling in the more expensive market. Over time the actions of the arbitrageur usually force
1.3 Derivative security 3

the markets back into equilibrium. Arbitrageurs make risk-free profits, although arbitrage
opportunities occur infrequently.

Summary

All these traders (hedgers, speculators and arbitrageurs) are important for the efficient operation
of futures and options market. For example if the market provides no economic function for the
speculator to assume the hedger’s risk, there would be no market. In this essay we focus on the
strategies hedgers use to minimise risk.

1.3 Derivative security

First what is a derivative? It is a financial instrument whose price depends on, or is derived from,
the price of another asset (that is an underlying asset)[3].

Definition 1.1 : A derivative security (also called a continent claim) is a financial contract whose
value at its expiry date T is fully determined by the prices at time T (or at a fixed range of times
within [0,T]) of the underlying assets.

Here are some examples of derivative securities:

1.3.1 Option

An option is a financial instrument which gives the holder the right, but not the obligation to trade
at a specified price, at (or by) a specified date. A call option gives the holder the right to buy
an asset, and a put option gives the right to sell an asset. The strike price X is the price at
which the future transaction will take place, and is fixed in advance at time 0 (now). The option
is called European if the transaction can take place only at the expiry (or exercise) date; while an
American options can be exercised at any trading date up to the expiry time. Note that in all of
these options it is only the option holder who has the choice to exercise or not. Most of the
work in this essay focuses on European options. To short an asset refers to selling of an asset not
owned by the seller with the intention of replacing it at a later date. On other hand, a short ( long)
position in an option contract refers to the position of the writer ( holder ) of the contract.

For a European call option with the stock price ST at expiry date T and with strike price X
will be exercised only if ST > X, since otherwise the trader could simply buy the stock from the
market for less than X and the option is worthless. Then the value of an option at time T is
VT = max{(ST − X), 0}. For t ∈ [0, T ], if St > X the call option is said to be in-the-money; when
St = X, the call option is said to be at-the-money; and finally when St < X, the call option is
said to be out-of-the-money. For the put option VT = max{(X − ST ), 0} and the inequalities are
reversed.
1.4 Important Formulae 4

1.3.2 Forwards and Futures

A forward contract is a binding agreement to buy or sell an asset S at future date T at a certain
future price. This contract must be fulfilled regardless of the future price. Unlike options there are
no premiums to be payed to enter into this contract. The price is arranged in such a way that at
time t = 0, neither the short nor the long position has a profit.

On the other hand in futures the price are determined by the law of supply and demand. The
contract is the same as in the case of forward contracts, but the exchange now requires both parties
to open margin accounts which will be monitored by the exchange (or clearing house). The clearing
house will adjust these marging accounts on a daily basis with some debits or deposits, according
to the market price movements.

1.3.3 Swaps

Swaps are exchanges between two partners of future cash flows according to agreed criteria that
depend on the value of some underlying assets. The swap market developed because two different
investors would find that while one of them had a comparative advantage in borrowing in one
market, he was at a disadvantage in the particular market in which he wanted to borrow. They
get the best of both worlds through a swap.

1.4 Important Formulae

This section provide some of the important formulae we need in the later chapters.

The most basic partial differential equation derived by Black-Scholes in 1973 on option pricing is
given by
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0 (1.1)
∂t 2 ∂S ∂S
where V is the value of the option contract at time t (maturing at time T ), σ is the volatility of an
asset which is the variable showing how the return of the underlying asset will fluctuate between
now and the expiration of the option, S is the stock price and r is the riskless interest rate.

By solving the differential equation (1.1) it can be shown that, the value C of a European call
option on a non-dividend paying stock is given by [11]

C = SN(d1 ) − Xe−r(T −t) N(d2 )


ln(S/X) + (r + σ 2 /2)(T − t)
with d1 = √ (1.2)
σ T −t
ln(S/X) + (r − σ 2 /2)(T − t) √
d2 = √ = d1 − σ T − t
σ T −t
1.4 Important Formulae 5

where N(d1 ) is the cumulative normal distribution of d1 , S is the stock price at time t, T is expiry
time of the option, X is the strike price or exercise price, and σ is the volatility of the underlying
stock.

The formula for a European put option P on a non-dividend paying stock is given by [11]

P = Xe−r(T −t) N(−d2 ) − SN(−d1 ) (1.3)

with d1 and d2 as in equation (1.2) and other symbols have the usual meaning.

Theorem 1.1 Call-Put Parity: Let C(S, t) and P (S, t) be the price at time t of a European call
and a European put option respectively, on the same underlying stock and with the same time to
the maturity T . Then
C(S, t) − P (S, t) = S − Xe−r(T −t)

where X is the strike price and S is the stock price at time t.

Similarly, for stock that pays a continuous dividend yield at rate q, the formula for a European call
option C is given by

C = Se−q(T −t) N(d1 ) − Xe−r(T −t) N(d2 )


ln(S/X) + (r − q + σ 2 /2)(T − t)
with, d1 = √ (1.4)
σ T −t
ln(S/X) + (r − q − σ 2 /2)(T − t) √
d2 = √ = d1 − σ T − t.
σ T −t
The value P of a European put option on dividend paying stock is given by

P = −Se−q(T −t) N(−d1 ) + Xe−r(T −t) N(−d2 ) (1.5)

with d1 and d2 as in equation (1.4).

The formula for a European call option C on currency with risk-free interest rate of foreign currency
rf is given by

C = Se−rf (T −t) N(d1 ) − Xe−r(T −t) N(d2 )


ln(S/X) + (r − rf + σ 2 /2)(T − t)
with, d1 = √ (1.6)
σ T −t
ln(S/X) + (r − rf − σ 2 /2)(T − t) √
d2 = √ = d1 − σ T − t.
σ T −t
The formula for a European put option P on a currency is given by

P = −Se−rf (T −t) N(−d1 ) + Xe−r(T −t) N(−d2 ) (1.7)

with d1 and d2 as in equation (1.6).


Chapter 2

The Greek Letters

In this chapter we establish the meaning of some Greek letters we use for hedging strategy. Each
Greek letter measures a different dimension of the risk in an option position and the aim of a trader
is to manage them so that all risks are minimised. We can express the formula for Greek letters
by using a binomial model [2] or by the Black-Scholes model (in discrete time [11] or continuous
time). In this essay we will use the continuous - time Black-Scholes model. Consider the following
example,

Example 2.1 Suppose that a financial institution has sold for £ 15000 a European call option on
N = 10000 shares of a (non-dividend paying) stock, that is C = £ 1.50 the price of each call.
Suppose that at the time the contract interred the stock price is S0 = £ 36, and that the strike price
is X = £ 37, the interest rate is r = 5% per annum (continuously compounded), the stock return
volatility is σ = 20% per annum. The time to maturity of the contract is T = 3 month (that is,
T = 0.24658 years), and the expected return on the stock is µ = 10% per annum.

The financial institution sold the call option at the price of C = £ 1.50 which is higher than the
theoretical value of C = £ 1.10 per each share predicted by the Black-Scholes equation (1.2). Now
the financial institution is faced with the problem of hedging its exposure.

2.1 Naked and Covered Position

Lets now investigate what kind of strategies the financial institution can adopt in example (2.1).
The financial institution can adopt what is called a naked position, which means doing nothing.
When the call expires, there are two possible cases:

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