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Chapter 17
1
The Greeks are coming!
The Greeks are coming!
Parameters of SENSITIVITY
Delta =
Theta =
Gamma =
Vega =
Rho =
2
c = SN(d1) – Ke–r(T – t)N(d2)
p = Ke–r)T –t)N(-d2) – SN(-d1)
Notationally:
c = c(S; K; T-t; r; σ)
p = p(S; K; T-t; r; σ)
Once c and p are calculated, WHAT IF?
3
The GREEKS are measures of sensitivity.
The question is how sensitive a position’s
value is to changes in any of the variables
that contribute to the position’s market
value.These variables are:
S, K, T-t, r and .
Each one of the Greek measures indicates
the change in the value of the position as a
result of a “small” change in the
corresponding variable.
Formally, the Greeks are partial derivatives.
4
Delta =
In mathematical terms DELTA is the first
derivative of the option’s premium with
respect to S. As such, Delta carries the
units of the option’s price; I.e., $ per share.
For a Call: (c) = c/S
For a Put: (p)= p/S
Results: (p) = (c) - 1
For the (S) = S/S = 1 5
THETA
Theta measures are given by:
(c) = c/(T-t) (p) = p/(T-t)
s are positive but the they are reported as
negative values. The negative sign only
indicates that as time passes, t increases,
time to expiration, T – t, diminishes and so
does the option’s value, ceteris paribus.
This loss of value is labeled the option’s
“time decay.”
6
Also, (S) = 0.
GAMMA
Gamma measures the change in delta when
the price of the underlying asset changes.
Gamma is the second derivative of the
option’s price with respect to the
underlying price.
(c) = (c)/S = 2c/ S2
(p) = (p)/S = 2p/ S2
Results: (c) = (p)
(S) = 0. 7
VEGA
Vega measures the sensitivity of the
option’s market price to “small” changes in
the volatility of the underlying
asset’s return.
(c) = c/
(p) = p/
Thus, Vega is in terms of
$/1% change in .
(S) = 0. 8
RHO
Rho measures the sensitivity of the option’s
price to “small” changes in the rate of
interest.
(c) = c/r
(p) = p/r
Rho is in terms of $/%change of r.
(S) = 0.
9
Example:
S=100; K = 100; r = 8%; T-t =180 days;
11
Call Delta (See Figure 15.2, page 345)
• Delta is the rate of change of the call
price with respect to the underlying
Call price
Slope =
C
A Stock price 12
THETA
Theta measures the sensitivity of the option’s
price to a “small” change in the time
remaining to expiration:
15
RHO
Rho measures the sensitivity of the
option’s price to “small changes in the
rate of interest.
(portfolio) = 0 17
DELTA neutral position in the simple case
of call-stock portfolios.
Vportfolio = Sn(S) + cn(c;S)
(portfolio) = (S)n(S) + (c)n(c;S)
(portfolio) = 0 n(S) + (c)n(c;S) = 0.
n(S) = - n(c;S)(c).
The call delta is positive. Thus, the negative
sign indicates that the calls and the shares
of the underlying asset must be held in
opposite direction.
18
EXAMPLE: call - stock portfolio
We just sold 10 CBOE calls whose delta is
$.54/shares. Each call covers 100 shares.
n(S) = - n(c;S)(c).
(c) = 0.54 and n(c) = -10.
n(c;S) = - 1,000 shares.
n(s) = - [ - 1,000(0.54)] = 540.
The DELTA-neutral position consists of the
10 short calls and 540 long shares.
19
The Hedge Ratio c
Definition: Hedge ratio.
Hedge Ratio
The number of shares required to neutralize the portfolio
The number of shares covered by the options
In the example:
Hedge ratio = 540/1,000 = .54
Notice that this is nothing other than (c).
20
In the numerical example, Slide 9:
The hedge ratio: (c) = 0.6151
With 100 CBOE short calls:
n(S) = -(c)n(c;S).
n(c;S) = -10,000.
n(S) = -(.6151)[-10,000] = +6,151 shares
The value of this portfolio is:
V = -10,000($10.3044) + 6,151($100)
V = $512,056
21
Suppose that the stock price rises by $1.
SNEW = 100 + 1 = $101/share.
V = - 10,000($10.3044 + $.6151)
+6,151($101)
V = - 10,000($10.3044) + 6,151($100)
- 10,000($.6151) + $1(6,151)
V = $512,056.
22
Suppose that the stock price falls by $1.
SNEW = 100 - 1 = $99/share.
V = - 10,000($10.3044 - $.6151)
+6,151($99)
V = - 10,000($10.3044) + 6,151($100)
- 10,000( - $.6151) - $1(6,151)
V = $512,056.
23
In summary:
The portfolio consisting of 100 short calls
and 6,151 long shares is
delta- neutral.
Price/share: +$1 -$1
shares +$6,151 -$6,151
calls +(-$6,151) -(-$6,151)
Portfolio $0 $0
24
DELTA neutral position in the simple case
of put-stock portfolios.
Vportfolio = Sn(S) + pn(p;S)
(portfolio) = (S)n(S) + (p)n(p;S)
(portfolio) = 0 n(S) + (p)n(p;S) = 0.
n(S) = - n(p;S)(p)
Since the put delta is negative, then the
negative sign indicates that the puts and
the underlying asset must be held in the
same direction.
25
EXAMPLE: put – stock portfolio.
We just bought 10 CBOE puts whose delta
is -$.70/share. Each put covers 100 shares.
n(S) = - n(p;S)(p).
(p) = -.70 and n(p) = 10.
n(p;S) = 1,000 shares.
n(S) = - 1,000(-.70) = 700.
The DELTA-neutral position consists of the
10 long puts and 700 long shares.
26
Portfolio: The portfolio consisting of 10
long puts and 700 long shares is
delta- neutral.
Price/share: +$1 -$1
shares +$700 -$700
puts -$700 $700
Portfolio $0 $0
27
In the numerical example, Slide 9:
V = 10,000($6.4360 - .3849)
+3,849($101)
V = $449,260.
29
Suppose that the stock price falls by $1.
SNEW = 100 - 1 = $99/share.
V = 10,000($6.4360 + $.3849)
+3,849($99)
V = $449,260.
30
In summary:
The portfolio consisting of 100 long puts
and 6,151 long shares is
delta- neutral.
Price/share: +$1 -$1
shares +$3,849 -$3,849
calls +(-$3,849) -(-$3,849)
Portfolio $0 $0
31
An extension:
calls, puts and the stock position
Vportfolio = Sn(S) + cn(c;S) + pn(p;S)
portfolio = (S)n(S) + (c)n(c;S) + (p)n(p;S)
But S = 1.
Thus, for delta-neutral portfolio:
portfolio = 0 and
n(S) = -(c)n(c;S) -(p)n(p;S). 32
EXAMPLE: We short 20 calls and 20 puts
whose deltas are $.7/share and -$.3/share,
respectively. Every call and every put
covers 100 shares.
How many shares of the underlying stock
we must purchase in order to create a
delta-neutral position?
n(S) = -(c)n(c;S) + [-(p)]n(p;S).
n(S) = -(.7)(-2,000) – [-.3](-2,000)
n(S) = 800.
33
Example continued
The portfolio consisting of 20 short calls,
20 short puts and 800 long shares is
delta- neutral.
Price/share: +$1 -$1
shares +$800 -$800
calls -$1,400 +$1,400
Puts +$600 -$600
Portfolio $0 $0
34
EXAMPLES
The put-call parity:
Long 100 shares of the underlying stock,
long one put and short one call on this
stock is always delta-neutral:
(position)
= 100 + (p)n(p;S) + (c)n(c;S)
= 100 + [(c) – 1](100) + (c)(-100)
= 0. 35
EXAMPLES
A long STRADDLE:
Long 15 puts and long 15 calls
(same underlying asset, K and T-t),
with: (c) = .64; (p) = - .36.
(straddle) = 15(100)[.64 + (- .36)]
=$420/share.
Long 420 shares to delta neutralize this
straddle.
36
Results:
1. The deltas of a call and a put on the same
underlying asset, (with the same time to
expiration and the same exercise price)
must satisfy the following equality:
(p) = (c) - 1
2. Using the Black and Scholes formula:
48
Interpretation of Gamma
The delta neutral position with 100 short
calls and 6,151 long shares has Γ= -$181
Position value
$512,056
75 100 125 S
More negative Γ
S S
delta-gamma-neutral.
52
53
54
55
VEGA
Vega measures the sensitivity of the option’s
market price to “small” changes in the
volatility of the underlying asset’s return.
(c) = c/
(p) = p/
56
57
58
59
60
RHO
Rho measures the sensitivity of the option’s
price to “small changes in the rate of interest.
(c) = c/r
(p) = p/r
61
62
63
64
65
SUMMERY OF THE GREEKS
66
The sensitivity of portfolios, a summary.
1. A portfolio is a combination of securities
and options.
2. All the sensitivity measures are partial
derivatives.
3. Theorem(Calculus): The derivative of a
linear combination of functions is the
combination of the derivatives of these
functions. Thus, the sensitivity measure
of a portfolio of securities is the portfolio
of these securities’ sensitivity measures.
67
Example:The DELTA of a portfolio of 5 long
CBOE calls, 5 short puts and 100 shares of
the stock long:
(portfolio) = (500c - 500p + 100S)
= (500c - 500p + 100S)/S
= 500c/S - 500p/S + 100
= 500c - 500p + 100
This delta reveals the $/share change in
the portfolio value as a function of a
“small” change in the underlying price
68
Example: S = $48.57/barrel.
1 call = 1,000bbls.
Call Delta Gamma
A $0.63/bbl $0.22/bbl
B $0.45/bbl $0.34/bbl
C $0.82/bbl $0.18/bbl
Portfolio:
Long: 3 calls A; 2 calls C; 5,000 barrels.
Short: 10 calls B. 69
Example:
= (0.63)3,000+ (0.82)2,000
+ (1)5,000 + (0.45)(-10,000)
= (0.22)3,000+ (0.18)2,000
+ (0)5,000 + (0.34)(-10,000)
= $4,030.
= - $2,380.
70
= 4,030 a “small” change of the oil
price, say one cent per barrel, will change
the value of the above portfolio by $40.30
in the same direction.
= - 2,380 a “small” change in the oil
price, say one cent per barrel, will change
the delta by $23.80 in the opposite
direction.
Also, Gamma is negative when the
price per barrel moves away from $48.57,
the portfolio value will decrease.
71
A financial institution holds:
5,000 CBOE calls long; delta .4,
6,000 CBOE puts long; delta -.7,
10,000 CBOE puts short; delta -.5,
Long 100,000 shares
(portfolio) = (.4)500,000 + (-.7)600,000
+(-.5)[-1,000,000]
+ 100,000
= $380,000. 72
GREEKS BASED STRATEGIES
Greeks based strategies are opened and
maintained in order to attain a
specific level of sensitivity. Mostly,
these strategies are set to attain zero
sensitivity. What follows, is an
example of strategies that are:
1. Delta-neutral
2. Delta-Gamma-neutral
3. Delta-Gamma-Vega-Rho-neutral
73
EXAMPLE:
The underlying asset is the a stock. The
options on this stock are European.
S = $300; K = $300; T = 1yr; = 18%;
r = 8%; q = 3%.
c = $28.25.
= .6245
= .0067
= .0109
= .0159
74
DELTA-NEUTRAL
Short 100 calls. n0 = - 10,000; Long nS = 6,245 shares
Case A1: S increases from $300 to $301.
Portfolio Initial Value New value Change
-100Calls - $282,500 - $288,800 - $6,300
6,245S $1,873,500 $1,879,745 $6,245
Error: - $55
Case A2: S decreases from $300 to $299.
Portfolio Initial value New value Change
-100Calls - $282,500 - $276,200 + $6,300
6,245S $1,873,500 $1,867,255 - $6,245
Error: + $55
75
Case B1: S increases from $300 to $310.
Portfolio Initial Value New value Change
-100Calls - $282,500 - $348,100 - $65,600
6,245S $1,873,500 $1,935,950 $62,450
Error: -$3,150
The point here is that Delta has changed significantly and
.6245 does not apply any more.
S = $300 $301 $310
= .6245 .6311 .6879.
We conclude that the delta-neutral portfolio must be
adjusted for “large” changes of the underlying asset price.
76
Call #0 Call #1
S = $300 S = $300
K = $300 K = $305
T = 1yr T = 90 days
= 18% r = 8% q = 3%
c = $28.25 c = $10.02
= .6245 = .4952
= .0067 = .0148
= .0109 = .0059
= .0159 = .0034 77
A DELTA-GAMMA-NEUTRAL PORTFOILO
(portfolio) = 0: nS + n0(.6245) + n1(.4952) = 0
Γ(portfolio)= 0: n0(.0067) + n1(.0148) = 0
Solution:
n0 = -10,000
n1 = - (-10,000)(.0067)/.0148 = 4,527
nS = - (-10,000)(.6245) – (4,527)(.4952) = 4,003
Short the initial call : n0 = -10,000
Long 45.27 of call #1 n1 = 4,527
Long 4,003 shares nS = 4,003 78
THE DELTA-GAMMA-NEUTRAL PORTFOLIO
Case A1: S increases from $300 to $301.
Portfolio Initial value New value Change
0) -10,000 - $282,500 - $288,800 -$6,300
1) 4,527 $45,360 $47,657 $2,297
S) 4,003 $1,200,900 $1,204,903 $4,003
Error: 0
Case B1: S increases from $300 to $310.
Portfolio Initial value New value Change
0) -10,000- $282,500 - $348,100 - $65,600
1) 4,527 $45,360 $70,930 $25,570
S) 4,003 $1,200,900 $1,240,930 $40,030
Error: 0
79
If we examine the exposure level to all parameters,
however, we observe that:
82
Delta-Gamma-Vega-Rho-neutral portfolio
CALL
0 .6245 .0067 .0109 .0159
1 .4954 .0148 .0059 .0034
2 .6398 .0138 .0055 .0044
3 .5931 .0100 .0080 .0079
83
The DELTA-GAMMA-VEGA-RHO-NEUTRAL-
PORTFOLIO
In order to neutralize the portfolio to all
risk exposures, following the sale of the
initial call, we now determine the
portfolio’s holdings such that all the
portfolio’s sensitivity parameters
are zero simultaneously.
= 0 and = 0 and = 0 and = 0
simultaneously!
84
=0
nS+n0(.6245)+n1(.4954)+n2(.6398)+n3(.5931)=0
=0
n0(.0067)+n1(.0148)+n2(.0138)+n3(.0100)=0
=0
n0(.0109)+n1(.0059)+n2(.0055)+n3(.0080) =0
=0
n0(.0159)+n1(.0034)+n2(.0044)+n3(.0079)85 =0
The solution is:
Exact n
Short 100 CBOE calls #0; -10,000
Short 339 calls #1; -33,927
Long 265 calls #2; 26,534
Long 204 calls #3; 20,420
Short 6,234 shares. -6,234
86
Case D: S increases from $300 to $310
r increases from 8% to 9%
increases from 18% to 24%
Portfolio Initial Value New value
0) - 10,000 - $282,468 - $428,071
S) - 6,234 - $1,870,200 - $1,932,540
1) - 33,927 - $340,023 - $664,552
2) 26,534 $405,668 $694,062
3) 20,420 $379,677 $622,240
TOTAL - $1,707,356 $1,708,861
Error:$1,505 or .088%.
87
DYNAMIC DELTA - HEDGING
The market stock price keeps changing all
the time. Thus, a static DELTA- neutral
hedge is not sufficient.
A continuous delta adjustment is not
practical.
An adjusted Delta-neutral Position:
1. Every day, week, etc.
2. Following a given % price change. 88
DYNAMIC DELTA HEDGING
Market makers provide traders with the
options they wish to trade. For example,
if a trader wishes to long (short) a call, a
market maker will write (long) the call.
The difference between the buy and sell
prices is the market maker’s
bid-ask spread.
The main problem for a market maker who
shorts calls is that the premium received,
not only may be lost, but the loss is
potentially unlimited.
89
DYNAMIC DELTA - HEDGING
Recall: The profit profile of an uncovered
call is:
P/L At expiration
c
K ST
90
DYNAMIC DELTA - HEDGING
Recall: The profit profile of a covered call
is:
Strategy IFC At expiration
ST < K ST > K
Short call c 0 -(ST – K)
Long stock -St ST ST
Total - St + c ST K
P/L ST - St + c K - St + c
91
DYNAMIC DELTA - HEDGING
Recall: The profit profile of a covered call is:
P/L At expiration
K –St+ c
K ST
-St + c 92
DYNAMIC DELTA - HEDGING
The Dynamic Delta hedge is based on the
impact of the time decay on the call Delta.
Recall that: St
ln[ ] [r .5σ ][T t]
2
d1 K
σ Tt
and
N(d1 ) Δ(c) 93
DYNAMIC DELTA - HEDGING
Observe what happens to d1
when T-t 0.
94
DYNAMIC DELTA - HEDGING
The Dynamic hedge:
1. Write a call and simultaneously, hedge
the call by a long Delta shares of the
underlying asset. As time goes by, adjust
the number of shares periodically.
Result: As the expiration date nears, delta:
goes to 0 in which case you wind
up without any shares.
goes to 1 in which case you call is
fully covered. 95
DYNAMIC DELTA - HEDGING
St : St < K St > K
(c): 0 1
Call: uncovered fully covered
n(S): 0 n(c;S) 1
96
Table 15.2 Simulation of Dynamic delta - hedging.(p.364)
Cost of
Stock Shares shares Cummulative Interest
Week przce Delta purchased purchased cost cost
($000) ($000) ($000)
0 49.00 0.522 52,200 2,557.8 2,557.8 2.5
1 48.12 0.458 (6,400) (308.0) 2,252.3 2.2
2 47.37 0.400 (5,800) (274.7) 1,979.8 1.9
3 50.25 0.596 19,600 984.9 2,966.6 2.9
4 51.75 0.693 9,700 502.0 3,471.5 3.3
5 53.12 0.774 8,100 430.3 3,905.1 3.8
6 53.00 0.771 (300) (15.9) 3,893.0 3.7
7 51.87 0.706 (6,500) (337.2) 3,559.5 3.4
8 51.38 0.674 (3,200) (164.4) 3,398.5 3.3
9 53.00 0.787 11,300 598.9 4,000.7 3.8
10 49.88 0.550 (23,700) (1,182.2) 2,822.3 2.7
11 48.50 0.413 (13,700) (664.4) 2,160.6 2.1
12 49.88 0.542 12,900 643.5 2,806.2 2.7
13 50.37 0.591 4,900 246.8 3,055.7 2.9
14 52.13 0.768 17,700 922.7 3,981.3 3.8
15 51.88 0.759 (900) (46.7) 3,938.4 3.8
16 52.87 0.865 10,600 560.4 4,502.6 4.3
17 54.87 0.978 11,300 620.0 5,126.9 4.9
18 54.62 0.990 1,200 65.5 5,197.3 5.0
19 55.87 1.000 1,000 55.9 5,258.2 5.1
20 57.25 1.000 0 0.0 5,263.3 97
Table 15.3 Simulation of dynamic Delta - hedging.(p. 365)
Cost of
Stock Shares shares Cumulative I nterest
Week price Delta purchased purchased cost cost
($000) ($000) ($000)
0 49,00 0.522 52,200 2,557.8 557.8 2.5
1 49.75 0.568 4,600 228.9 2,789.2 2.7
2 52.00 0.705 13,700 712.4 3,504.3 3.4
3 50.00 0.579 (12,600) (630.0) 2,877.7 2.8
4 48.38 0.459 (12,000) (580.6) 2,299.9 2.2
5 48.25 0.443 (1,600) (77.2) 2,224.9 2.1
6 48.75 0.475 3,200 156.0 2,383.0 2.3
7 49.63 0.540 6,500 322.6 2,707.9 2.6
8 48.25 0.420 (12,000) (579.0) 2,131.5 2.1
9 48.25 0.410 (1,000) (48.2) 2,085.4 2.0
10 51.12 0.658 24,800 1,267.8 3,355.2 3.2
11 51.50 0.692 3,400 175.1 3,533.5 3.4
12 49.88 0.542 (15,000) (748.2) 2,788.7 2.7
13 49.88 0.538 (400) (20.0) 2,771.4 2.7
14 48.75 0.400 (13,800) (672.7) 2,101.4 2.0
15 47.50 0.236 (16,400) (779.0) 1,324.4 1.3
16 48.00 0.261 2,500 120.0 1,445.7 1.4
17 46.25 0.062 (19,900) (920.4) 526.7 0.5
18 48.13 0.183 12,100 582.4 1,109.6 1.1
19 46.63 0.007 (17,600) (820.7) 290.0 0.3
20 48.12 0.000 (700) (33.7) 256.6 98