Concept of Greeks in Corporate Risk Management

Introduction of Option Greeks

Option Greek refers to the sensitivity of option prices with respect to one of its determinants. are:

Option Greeks 1. Delta 2. Gamma 3. Theta 4. Vega 5. Rho

Following are the Greeks of Option

Greek Letter Variable/Determinant of OP

Delta Theta Gamma Rho Vega

Change of asset price Time left for maturity Change in delta Change in risk-free rate Change in volatility

Option Delta
It is the rate of change of option price with respect to the price of the underlying asset. Option delta denoted by is defined as first partial derivative of the price of the option with respect to the change in the spot price. Delta of call is c = C/S Where, C = change in the value of the call option, and S = change in the spot price of the underlying asset

Computing Delta
In

terms of Black Scholes Model, the delta of call is c = C/S = N(d1)

Delta

of put option is p = P/S = N(-d1) = N(d1) - 1

Values of Option Delta

Value of N(d1) is between 0 and 1 the delta of call would always be 0 and 1. delta of put option is always between 0 and 1. Positive delta implies that change would be in the same direction as that of the asset price. Negative value of delta means that change in option value would be in opposite direction.

Meaning of Delta
An option delta of 0.5724 means that if the value of the underlying changes by Rs 1 the value of the option would change by Rs 0.5724. Delta is referred as hedge ratio indicating how many units of underlying asset are required to replicate the returns of the option.

Applying Delta - Example

Given following information about a stock option: Stock price = Rs 300, Strike Price = Rs 300, t = 3 months, risk free return = 8%, standard deviation = 30%. 1. Find out the value of the call using Black Scholes Model and its delta. 2. What interpretation you give to delta? 3. If the value of the stock increases by 1% by what amount the call value would change? What would be the new value of the call using delta and the BSM?

Additivity of Delta
Additivity implies that delta of portfolio of assets is weighted sum of the deltas of the securities comprising it. It is represented as: = w11+ w22+w33= wii

Where wn is the number of nth options and n is delta of option position on the same asset.

Portfolio Delta: Example

Under the Black Scholes model the value of N(d1) is 0.75. What would be delta of portfolios consisting of a) 4 long positions in stock and 4 calls b) b) 4 long positions of stock and 4 puts c) c) 4 long calls and 4 long puts? d) Which of the portfolios has least sensitivity to the changes in the stock price?

Delta for Different Assets

Asset For nondividend paying N(d1) N(d1) - 1 0 For dividend paying @ q (continuously compounded) e-qt * N(d1) e-qt* [N(d1) 1] 0 Call on stock Put on stock Bond

Stock
Forward contract on stock Futures contract on stock Call option on foreign currency Put option on foreign currency Call option on futures Put option on futures

1
1 ert

e-qt
e-qt e(r-q)t e-r,t * N(d1) e-r,t* [N(d1) 1] e-r,t * N(d1) e-r,t* [N(d1) 1]

Theta
is the sensitivity of option value with respect to time. is also referred to as the time decay of the portfolio. Mathematically, time value of an option can be expressed as: c = - c/t for call p = - p/t for put The negative sign denotes that with passage of time the time remaining for maturity decreases, and hence theta decreases.

Theta
For a non-dividend paying stock the thetas for call and put are given by: c = - SN(d1) rXe-rtN(d2) 2t p = - SN(d1) rXe-rtN(-d2) 2t Where, N(d1) = 1 2
2 -0.5d e

Computing Theta
Note that the value of theta for call would always be negative representing that the time value decays with passage of time. Example: For a 3-month at-the-money call on a stock selling at Rs 500 with risk free rate of 6% and volatility of 25% the call sells at Rs 28.64 and what is the value of theta?

Interpreting Theta
Call sells at Rs 28.64 while the time decay occurs at the rate of Rs 64.49. Note that the value of theta is annual while the call has maturity of three months only. Theta if expressed on per day basis would make better sense. Transforming the value of Rs 64.49 the option would lose value of Rs 0.1767 every day (Rs 64.49/365). contd

Interpreting Theta

We can either measure per calendar day or per trading day. To obtain the per calendar day, the formula for theta must be divided by 365; to obtain per trading day, it must be divided by 250.

Gamma ()
Gamma is the rate of change of the options delta with respect to the price of the underlying asset. is the second partial derivative of delta with respect to spot price. 2 2

= C/S or c/S for call option, and 2 2 p = P/S or p/S for put option

Since c= N(d1) and p= N(d1) -1, i.e. they differ only by a constant. Change of delta i.e. the value of gamma for call and put would be identical and is given by: = N(d1) St Where, 2 N(d1) = 1 e-0.5d 2

Portfolio Gamma
Like delta, gamma is additive. Gamma of the portfolio is weighted average of the gammas of the securities consisting it.

p= n1 x 1+ n2 x 2+n3 x3 ni x i

Computing Gamma

Example: For ATM call with Spot = Rs. 500, X = Rs. 500, r = 6%, t = 3 months (0.25 years), standard deviation = 25% and what is the value of gamma?

Vega ()
Vega is the rate of change of value of the option with respect to the volatility of the underlying asset. c = C/ for call and p = P/ for put It is same for call and put option. In terms of the BSM, Vega for option on a non-dividend paying stock is given by: Vega = St N(d1)

Meaning of Vega
Vega is positive both calls and puts. Irrespective of the nature of options increased volatility means increased valuation of the option and vice versa. Only historical volatility can be measured while the estimates of future volatility is implied in the option price. Vega is a measure of change in the value with change in the implied volatility.

Rho ()
Rho is rate of change of value of option with respect to changes in the risk free interest rate. Rho for call and put options are defined as: c = C/r for call and p = P/r for put Rho for call and put options for non-dividend paying stock are given as: For call option: c = tXe-rtN(d2) For put option: p = -tXe-rtN(-d2)