K.Cuthbertson and D.

Nitzsche
1
FINANCIAL ENGINEERING:
DERIVATIVES AND RISK MANAGEMENT
(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

LECTURE

Dynamic Hedging and the Greeks
1/9/2001
K.Cuthbertson and D.Nitzsche
Topics
Dynamic (Delta) Hedging

The Greeks

BOPM and the Greeks


K.Cuthbertson and D.Nitzsche
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Dynamic Hedging

K.Cuthbertson and D.Nitzsche
Dynamic (Delta) Hedging
Suppose we have written a call option for C
0
=10.45 (with
K=100, o = 20%, r=5%, T=1) when the current stock price is
S
0
=100 and A
0
= 0.6368

At t=0, to hedge the call we buy A
0
= 0.6368 shares at So =
100 at a cost of $63.68. hence we need to borrow (i.e. go into
debt)

Debt , D
0
= A
0
S
0
- C
0
= 63.68 10.45 = $53.23


K.Cuthbertson and D.Nitzsche
Dynamic Delta Hedging
At t = 1 the stock price has fallen to S
1
= 99 with A
1
= 0.617.
You therefore sell (A
1
- A
0
) shares at S
1
generating a cash inflow
of $1.958 which can be used to reduce your debt so that your
debt position at t=1 is

53.23 - 1.958 = 51.30

The value of your hedge portfolio at t = 1(including the market
value of your written call):

V
1
=


= Value of shares held - Debt - Call premium
= = 0.0274 (approx zero)
But as S falls (say) then you sell on a falling marker ending up with
positive debt
( ) = A A =
A
1 1 1
S e D D
o
t r
o
) 01 . 0 ( 05 . 0
e
1 1 1 1
C D S A
K.Cuthbertson and D.Nitzsche
Dynamic Delta Hedging
OPTION ENDS UP OUT-OF-THE-MONEY (A
T
= 0 shares)

$ Net cost at T: D
T
= 10.19
% Net cost at T: (D
T
- C
0
) / C
0
= 2.46%

OPTION ENDS UP IN THE-MONEY (A
T
= 1 share)

$ Net cost at T: D
T
K = 111.29 100 = 11.29
% Net cost at T: (D
T
K - C
0
) / C
0
= 8.1%

% Cost of the delta hedge = risk free rate

%Hedge Performancer = sd( D
T
e
-rT
- C
0
) / C
0


K.Cuthbertson and D.Nitzsche
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THE GREEKS
K.Cuthbertson and D.Nitzsche
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Figure 9.2 : Delta and gamma : long call
0
0.2
0.4
0.6
0.8
1
1.2
1 11 21 31 41 51 61 71 81 91
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
Delta
Gamma
Stock Price (K = 50)
K.Cuthbertson and D.Nitzsche
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THE GREEKS: A RISK FREE HOLIDAY ON THE ISLANDS
2
2
S
f
c
c
= I
o c
c f
= A
Gamma and Lamda
df ~ A.dS +(1/2) I (dS)
2
+ O dt + dr + A do

K.Cuthbertson and D.Nitzsche
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HEDGING WITH THE GREEKS:
Gamma Neutral Portfolio
I = gamma of existing portfolio
I
T
= gamma of new options

I
port
= N
T
I
T
+ I = 0

therefore buy : N
T
= - I/I
T
new options

Vega Neutral Portfolio
Similarly : N
A
= -A / A
T
new options

K.Cuthbertson and D.Nitzsche
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HEDGING WITH THE GREEKS

ORDER OF CALCULATIONS

1) Make existing portfolio either vega or gamma neutral
(or both simultaneously, if required in the hedge) by
buying/selling other options. Call this portfolio-X

2) Portfolio-X is not delta neutral. Now make portfolio-X delta
neutral by trading only the underlying stocks (cant trade
options because this would break the gamma/vega
neutrality).

K.Cuthbertson and D.Nitzsche
12
Hedging With The Greeks: A Simple Example
PortfolioA: is delta neutral but I = -300.
A Call option Z with the same underlying (e.g. stock) has a
delta = 0.62 and gamma of 1.5
.
How can you use Z to make the overall portfolio gamma and
delta neutral?

We require: n
z
I
z
+ I = O
n
z
= - I / I
z
= -(-300)/1.5 = 200
implies 200 long contracts in Z
The delta of this new portfolio is now
A = n
z
.A
z
= 200(0.62) = 124
Hence to maintain delta neutrality you must short 124
units of the underlying.
K.Cuthbertson and D.Nitzsche
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BOPM and the Greeks
K.Cuthbertson and D.Nitzsche
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Figure 9.5 : BOPM lattice
Index, j
Time, t
1,0 2,0 3,0 4,0
0,0
1,1
2,2
3,3
4,4
2,1 3,1 4,1
3,2 4,2
4,3
1 0 2 3 4
K.Cuthbertson and D.Nitzsche
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BOPM and the Greeks

Gamma


S* = (S
22
+ S
21
)/2 and in the lower part, S** = (S
21
+ S
20
)/2.
Hence their difference is:

[9.32] = ] /2 =




10 11
10 11
00
S S
f f

= A
21 22
21 22
11
S S
f f

= A
20 21
20 21
10
S S
f f

= A
) ( ) [(
20 21 21 22
S S S S + + 2 / ) (
20 22
S S

10 11
00
A A
= I
K.Cuthbertson and D.Nitzsche
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End of Slides