Chapter 19

Using Options for Risk Management

I. The Greeks
II. Riskless Hedging
III. Delta Hedging and Delta-Gamma Hedging
IV. Position Deltas and Position Gammas
V. Time Spreads
VI. Caps, Floors, and Collars

David

The Greeks
C
C
S

Delta

0 C N(d1 ) 1

C 2C
2 C 0
S
S

Gamma

P
P
S

- 1 P N(d1 ) - 1 0

P 2P

P 0
S S 2

Theta1

C
C 0
T

P
P, American 0
T

Vega

C
VC 0

P
VP 0

Rho

C
C 0
r

P
P 0
r

Theta is often expressed as a negative number

David

We Know that the Value of a Call Option

Depends on the Values of:

Stock Price
Time to Expiration
Volatility
Riskless interest rate (generally assumed to be constant)
Dividend yield (generally assumed to be constant)
Strike Price (never changes)

David

Accordingly, as These Factors

Change over time:
The value of the call option will change over time.
This is important for risk management because the composition
of a riskless hedge must, therefore, change over time.

David

Some Intuition From Using a Taylor-Series Expansion

Given value at x0, we can use derivatives of function to approximate value of

function at x:
f(x) = f(x0) + f ' (x0) (x-x0) + (1/2) f '' (x0)(x-x0)2 + ...

Incorporate curvature effects via Second-order Taylor series expansion of

option price around the stock price (quadratic approximation):
C(S + dS) = C(S) + (C/S) dS + (0.5) 2C/S2 (dS)2
= C(S) +
dS + 0.5
(dS)2

So, the change in the call price, given a change in S is:

C(S + dS) - C(S) = dS + 0.5 (dS)2 +
dC

= dS + 0.5 (dS)2 +

David

Delta AKA: Hedge Ratio

Delta () is the rate of change of the option price with respect to
the underlying. (I.e., How does the option price change as the
underlying price changes?)

Option
price
Slope =

B
A

Stock price
David

Gamma Addresses Delta Hedging Errors

Caused By Curvature
Call
price
C
C
C

Stock price
S

S
David

Stock Price:
Strike Price:
Volatility:
Time to Expiration:
Riskless Rate:
Dividend Rate:

68
65
0.50
0.25
0.035
0

Black-Scholes Call:
Black-Scholes Put:

8.52
4.96

Call Price as a Function of Stock Price,

All Else Equal
16.00
14.00

Call Price

12.00
10.00
8.00
6.00
4.00
2.00
0.00
40

45

50

55

60
Stock Price

65

70

75

80

Stock
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75

David

Call
1.14
1.34
1.56
1.81
2.07
2.37
2.69
3.03
3.40
3.80
4.22
4.67
5.15
5.65
6.17
6.72
7.30
7.90
8.52
9.17
9.83
10.52
11.22
11.95
12.69
13.45

Stock Delta
Delta as a Function of the Stock Price
1
0.9
0.8
0.7

Delta

0.6
0.5
0.4
0.3
0.2
0.1
0
35

45

55

65
Stock Price

75

85

95

36
38
40
42
44
46
48
50
52
54
56
58
60
62
64
66
68
70
72
74
76
78
80

David

0.0138
0.0234
0.0374
0.0563
0.0806
0.1107
0.1462
0.1869
0.2319
0.2804
0.3314
0.3837
0.4364
0.4884
0.5390
0.5875
0.6333
0.6760
0.7154
0.7513
0.7839
0.8131
0.8390

Example:

An investment bank has sold (for $300,000) a European call

option on 100,000 shares of a non-dividend paying stock: i.e,

S0 = 49,

The Black-Scholes value of the option is $240,000.

How does the investment bank hedge its risk?

K = 50, r = 5%, s = 20%, T = 20 weeks

David

Two Alternatives:

Naked position:
Take no action (other than deep breath and hope for
the best).
Risk: Stock price is greater than $53 at expiration.

Covered position:
Buy 100,000 shares today.
Risk: Stock price is less than $46 at expiration.

David

Stop-Loss Strategy Which Involves:

Buying 100,000 shares as soon as price reaches $50.

Selling 100,000 shares as soon as price falls below $50.

NB: This deceptively simple hedging strategy does not

work well. Main failure: Bid-Ask Spreads. (Think about
bid-ask bounce)

David

Delta Hedging

This involves maintaining a delta neutral portfolio.

The delta of a European call on a non-dividend paying stock is
N (d 1).

The delta of a European call on a stock paying dividends at

rate q is N (d 1)e qT.

The delta of a European put is on a non-dividend paying stock

is: [N (d 1) 1].

The delta of a European put on a stock paying dividends at

rate q is e qT [N (d 1) 1].

David

Delta Hedging, Cont.

N.B. The hedge position must be rebalanced frequently.

(Delta Hedging is a concept born from Black-Scholes, I.e., in
continuous time.)

Delta hedging a written option involves a buy high, sell low

trading rule. (I.e., When S increases, so does Delta, and vice
versa.)

Data from above:

S0 = 49, K = 50, r = 0.05, = 0.20, T = 20 weeks (0.3846)
Option written on 100,000 shares, selling price: $300,000
Black-Scholes value of this option: $240,000

David

A Closer Look at Delta Hedging

Important:
Option on 100,000 shares
Volatility is assumed constant.
Rebalancing assumed weekly.

Week
0
1
2
3
4
5
6
7
8
9

Stock
Price
49.000
48.125
47.375
50.250
51.750
53.125
53.000
51.875
51.375
53.000

Delta
0.522
0.458
0.400
0.596
0.693
0.774
0.771
0.706
0.674
0.787

Delta *
100,000
52200
45800
40000
59600
69300
77400
77100
70600
67400
78700

Starting Shares Cost (in Cumula- Interest

Shares
B/S
000's) tive Cost (in 000's)
0
52,200 2,557.80 2,557.8
2.5
52,200
-6,400 -308.00 2,252.3
2.2
45,800
-5,800 -274.78 1,979.7
1.9
40,000
19,600
984.90 2,966.5
2.9
59,600
9,700
501.98 3,471.3
3.3
69,300
8,100
430.31 3,904.9
3.8
77,400
-300
-15.90 3,892.8
3.7
77,100
-6,500 -337.19 3,559.3
3.4
70,600
-3,200 -164.40 3,398.4
3.3
67,400
11,300
598.90 4,000.5
3.8

David

Aim of Delta Hedging: Keep Total Wealth

Unchanged. Lets look at the end of Week 9.

Value of written option at start: $240,000 (per B-S.)

Value of option at week 9 (=20%): $414,500.
Option Position Loss: $(174,500).
Cash Position Change, (Measured by Cum. Cost: $2,557,800
4,000,500 = $(1,442,700).
Value of Shares held:
At start: 49 * 52,200 = $2,557,800
At end of week 9: 53 * (67,400 + 11,300) = $4,171,100.
Increase of: $1,613,300.

Net: $1,613,300 1,442,700 174,500 = $(3,900).

David

More on Delta Hedging

Delta is the (fractional) number of shares required to hedge one call.

Positions in the fractional shares and call have opposite signs.

For calls, delta lies between 0 and 1.
For puts, delta lies between 1 and 0.
Strictly speaking, the riskless hedge exists only for small changes in the
stock price and over very small time intervals.
As time passes and/or the stock price changes, the of the call
changes (as measured by gamma).
As changes, shares of stock must be bought or sold to maintain the
riskless hedge.

David

Gamma
Gamma () is the rate of change of delta () with respect to the
price of the underlying asset.
This varies with respect to the stock price for a call or put
option. (reaches a maximum at the money).
As a rule, we would prefer to have a positive Gamma (more on
this later)

David

Interpretation of Gamma
For a delta neutral portfolio, d dt + dS2

d
dS
dS

Positive Gamma

Negative Gamma
David

Position, or Portfolio, Deltas

The position delta determines how much a portfolio changes in value if

the price of the underlying stock changes by a small amount.

The portfolio might consist of several puts and calls on the same stock,
with different strikes and expiration dates, and also long and short
positions in the stock itself.

The delta of one share of stock that is owned equals +1.0. The delta of
a share of stock that is sold short is 1.0. Why?

David

Calculating a Position Delta

Assuming that each option covers one share of stock, the

position delta is calculated as a weighted sum of individual
deltas. That is,

n
i

i 1

where ni is the number of options of one particular type, or the

number of shares of stock.
The sign of ni is positive if the options or stock is owned, and
negative if the options have been written or the stock sold short.
The delta of the ith option or stock is given by i.

David

An Example of a Position Delta

Suppose you have positions in the following assets:
Position and number
of options or shares
long 300 shares
long 40 puts
short 150 calls
long 62 calls

ni___
+300
+40
-150
+62

delta/unit Total Deltas=ni i

1.00
-0.46
0.80
0.28

300.00
-18.40
-120.00
17.36
p = 178.96

This assumes that each option is on one share of stock

David

In this example, the position delta of 178.96 is positive.

This means that if the stock price were to increase by one dollar,
the value of this portfolio would rise by $178.96.

If the stock price were to decline by one dollar, then the value of
this portfolio would fall by $178.96. (Remember that this
example assumes that the underlying asset of an option is one
share of stock.)

Knowing your portfolio's position delta is as essential to

intelligent option trading as knowing the profit diagrams of your
portfolio.

David

Position Gammas
Similar to position deltas, a position gamma is the weighted sum of the
gammas of the elements of the portfolio:

i i

i 1

where ni is the number of options of one particular type. The sign of ni is

positive if the option is owned, and negative if the option has been
written.

The gamma of the ith option is given by i. Note that the gamma of a
stock is zero, because the delta of a stock is always equal to one.

David

Ideally, a delta neutral hedger would like to maintain a portfolio

with a positive gamma.

Recall that the gamma of a call or a put are given by the same
formula and that gammas cannot be negative.

However, a portfolio can have a positive or negative gamma.

It is important to note that a portfolio with a positive gamma

increases in value if the underlying stock value changes.

Further, a portfolio with a negative gamma decreases in value if

the underlying stock value changes.

David

Time Spreads, I.
Time spreads are also sometimes called calendar
spreads or horizontal spreads.
Time spreads are identified by the ratio of options
written and purchased.
To create a 1:1 time spread, the investor buys one
option and sells one option.
The two options must either be both calls, or both puts, and
share the same strike price on the same underlying asset.
However, unlike most of the option portfolios discussed
previously, the time spread portfolio of options has options
with different maturity dates.

David

Time Spreads, II.

The maximum profit on a time spread occurs when
the stock price equals the strike price on the
expiration date of the nearby call.
The short-term written option expires worthless, and
the longer term option can be sold with some time
value remaining.
An important risk to be kept in mind is that if the written,
short-term option is in-the-money as its expiration date
nears, it could be exercised early.
Thus, in-the-money time spreads using American options will
often have to be closed out early in order to preclude this
possibility.

David

Neutral Time Spreads

A neutral time spread is a strategy designed to
capitalize on two options that are somehow mispriced relative to each other.
The two options differ only in their times to expiration.
Usually the short-term option is written and the longer
option is purchased.
The number of each option traded is designed to
create a delta neutral portfolio.

David

Neutral Time Spreads, Example

Suppose the implied standard deviations of the two options
were 0.4043 (for a September call), and 0.3262 (for a December
call.)
Thus, assuming that the BSOPM is the proper pricing formula,
the short-term call is overvalued relative to the December call.
Assume that the "true" volatility is 0.40/year.
Then, the hedge ratios of the two options are = 0.4439 for the
September call, and = 0.5415 for the December call.
A delta neutral portfolio of these two options is:

= 0 = n11 + n22

David

Rearranging:

n1 2

n2
1
Using the above deltas, and denoting the September and
December calls as assets 1 and 2, respectively:

n1 0.5415

1.22
n2
0.4439

(19 - 6)

Equation (19-6) says that to create a delta neutral position: 1.22

September calls should be sold for each December call
purchased.
This allows the investor to arbitrage the relative mispricing of the
two options, and not speculate on price movements.

David

Caveats
Of course, there are real risks and costs that must be included.
For example, we have ignored transactions costs.
In practice, the position will have to be closed out early if the
options are in the money as September 21 nears, because the
September call could be exercised early.
If they are exercised, the trader will bear additional transactions
costs of having to purchase the stock and making delivery. In
addition, there are rebalancing costs of trading options to maintain
delta neutrality. For this reason, neutral hedgers prefer low gamma
positions, if possible.

We assumed there are no ex-dividend dates between August 1

and September 21. Dividends would affect the computed deltas
and also introduce early exercise risk.
We assumed constant interest rates and constant volatility.
These also affect the computed deltas and indeed, may be the
source of the apparent mispricing.

David

Caps
A cap is a purchased call option in which the underlying
asset is an interest rate.
Note that a call on an interest rate is equivalent to a put
on a debt instrument.
The interest rate cap is actually established when the
interest rate call is combined with an existing floating
rate loan. The call caps the interest that can be paid on
the floating rate liability.

David

Buying a cap provides insurance against an

interest rate increase that hurts the firm
V

long call (at the money)

A rise in interest
rates increases
interest expense.
David

Buying a cap provides insurance against an

interest rate increase that hurts the firm
V

long call
r

resulting exposure
The firm benefits from a decline in r, but has bought
insurance to protect itself from a rise in r.
David

Caps
An interest rate call is purchased along with a variable
rate loan to create the cap. The borrower then pays:
~
r
if r < rc
rc

if r > rc

The interest rate call payments themselves are:

(r - rc) (notional principal) (d/360)
if r > rc
0

if r < rc

where: rc is the cap rate (strike price), and d is the # of

days in the settlement period.
David

Effective Interest Cost under a Cap

Interest
Expense

rc
David

An Example of a Caplet
Suppose the cap rate is 7.00%.
If:
the reference interest rate (3-month LIBOR) is 7.90% on the
settlement date,
there are 90 days in the settlement period,
and, NP = $15,000,000.

Then, the payment is:

(0.079 - 0.070) ($15,000,000) (90/360) = $33,750

A cap is a portfolio of caplets, each having a different

expiration (reset) date.
David

The Cap Premium

When purchased along with a floating rate loan, the cap
premium is often amortized, and just added to the periodic
interest rates.
Example.
A firm borrows $15,000,000 at LIBOR, with 8 semiannual
payments.
A cap will cost $300,000. PV = -300,000, i = .035*, n = 8
=> caplet PMT = $43,643.

This will add 43,643/15,000,000 = 29 basis points per

semiannual payment = 58 bp per year to the loan
That is, the firm will pay LIBOR + 58bp, capped at 7.58% per
annum.

David

Floors
An interest rate floor is a put on an interest rate ( = a
call on a debt instrument).
Lenders, or institutions that own floating rate debt (an
asset), purchase interest rate floors.
The floor is actually created when the interest rate
put is combined with the floating rate asset. The put
places a floor (a minimum) on how low the
institutions interest income can be.

David

Firm buys an at the money interest rate put

V

r
raw
exposure

long put

Firm is exposed to the risk that interest rates will decline

David

The Interest Rate Floor is Insurance Against

Declining Interest Rates
V

Net Exposure

Net Exposure

r
Raw
Exposure

long put

Firm is exposed to the risk that interest rates will decline. Buying
the interest rate put = buying insurance.

David

Floors
Combine a floating rate asset with a floor. The lender then
receives:

~
r

if r > rf

rf

if r < rf

The floor payments themselves are:

(rf - r) (notional principal) (d/360) if r < rf
0

if r > rf

where: rf is the floor rate (strike price), and d is the # of

days in the settlement period.
David

Effective Interest Income with a Floor

Interest
Income

r
rF
David

Interest Rate Collars

A collar combines the purchase of a cap at a high strike price
with the sale of a floor at a low strike price.
Frequently, the cost of the cap equals the selling price of the
floor, so that a zero cost collar is purchased.
A collar allows a firm with a floating rate liability to insure itself
from the undesired impact of an interest rate rise, but pays
for it by giving up the benefits of a rate decline.

David

Interest Rate Collar

Profit

Long Call
rc
r

rf
Written put
David

Interest Rate Collar

Profit

rf

rc

David

Interest Rate Collar

Profit

rf

rc

The underlying risk exposure is to rising interest rates

David

Interest Rate Collar:

Profit

rf

rc

underlying risk exposure

David

Effective Interest Expense

Under a Collar
Interest Expense

rf

rc

r
David

Interest Rate Corridors

Corridors are purchased by a firm with a floating rate
liability. The firm buys an interest rate call with a
(relatively) low strike price, and sells a cheaper one
with a higher strike price.
Profit

buy low rc cap

(in-the-money)

sell cheaper higher rc cap

(out-of-the-money)

David

Interest Rate Corridors

profit

r
underlying risk exposure
profit
r

The firm is hedged

only within a range of
interest rates

David

Cap - Floor Parity

Recall that C - P = S - PV(K), and that the zero profit
point for buying a call and selling a put is the
theoretical forward price.
The zero profit point for buying a cap and selling a
floor is the theoretical price for a fixed - for - floating
interest rate swap.

David

Extra Material
What follows is are examples of a delta neutral
strategy and a delta-gamma neutral strategy

David

Example:
Suppose S = K = $100, r = 8%, = 30%, and T = 180 days.
Then, by using the BSOPM, one can generate the following
information:
Variable
Price
Delta
Gamma

Call Option
$10.30
0.6151
0.0181

Put Option
$6.44
-0.3849
0.0181

Stock
$100
1
0

David

Now, suppose a trader is considering using either calls or puts

to maintain a delta neutral portfolio. This can be accomplished
with the purchase of puts or by writing calls.
Using Puts:
Delta Neutral Strategy: Long 1 put at $6.44; long 0.3849 shares at
$100/share.
Positive Position Gamma: (1* 0.0181) + (0.3849* 0) = 0.0181.

Stock
Price

90
100
110

Value of
Put 0.3849 Port.
Pct. Chg.
Price Shares Value (From S=100)

11.25
6.44
3.41

34.64
38.49
42.34

45.89
44.93
45.75

2.14
1.83

David

Using Calls:
Delta Neutral Strategy: Short 1 call at $10.30; long 0.6151 shares at
$100/share. Note that this results in a Negative Position Gamma: (-1*
0.0181) + (0.6151* 0) = -0.0181.

Stock
Price

90
100
110

Value of
Call 0.6151 Port.
Pct. Chg.
Price Shares Value (From S=100)

5.12 55.36 50.24

10.30 61.51 51.21
17.28 67.66 50.38

-1.89
-1.62

David

Note that when the delta hedger constructs a portfolio using puts, the
value of the portfolio increases, regardless of the direction of the
change in the underlying asset price.
However, in the case where calls are used, the portfolio value falls
whether the underlying asset price increases or decreases.
From a cost standpoint, a delta neutral hedger would like to have a
portfolio with a low, but positive gamma. Recall that gamma measures
changes in delta, and that deltas change as S, T, , and/or r change.
Thus, a portfolio that is delta neutral portfolio today may not be delta
neutral tomorrow.
A low position gamma will mean that the delta neutral investor will
conserve on the transactions costs of readjusting the portfolio delta
back to zero if S changes.
But a positive gamma at least compensates a trader for bearing the risk
of fluctuating delta, because the value of the portfolio will increase if the
underlying assets price changes, all else equal.

David

Generalized Portfolio Sensitivities

Traders can create portfolios that are neutral (insensitive) to any single
Greek or combination of Greeks.

From the examples above, you can see that a trader needs one option
to remove one effect.

In the example above, the trader made the portfolio insensitive to

changes in the stock price using a delta neutral strategy (i.e., recall that
traders can use either calls or puts in a delta neutral strategy).

To neutralize additional effects, traders must add additional securities to

their portfolios.

David

Delta-Gamma Hedge

To remove delta effects via a delta-neutral hedging strategy using

options, the trader employed one option.
To remove another effect, i.e., gamma, the trader will need to use a
second option. Suppose S = K1 = $100, r = 8%, = 30%, T = 180
days, and K2=110. Then, by using the BSOPM, one can generate the
following information.

Variable
Price
Delta
Gamma

Call Option
(K=100)
$10.30
0.6151
0.0181

Call Option
(K=110)
$6.06
0.4365
0.0187

Stock
$100
1
0

David

Suppose the trader decides to sell 200 call options with the strike of
100, each on 100 shares of stock.
Because the trader wants to create a delta-gamma hedged portfolio,
the trader must simultaneously solve for the number of shares to
purchase, S, and the number of K=110 calls to purchase, K110.
This is straightforward because the gamma of the stock is zero, and the
portfolio gamma is a weighted sum of the constituent gammas. The
trader wants a gamma of zero. That is,
0 = (-200*100*0.0181) + (S*0) + (K110*100*0.0187)

which yields K110 = 193.583 for any value of S.

David

Assuming the trader buys 194 of the calls having a strike price of 110.
Solving for the number of shares is accomplished by noting that the
delta of a share equals one and that the trader also wants to hold a
delta neutral portfolio. Accordingly,
0 = (-200*100*0.6151) + (S*1) + (194*100*0.4365)

Therefore S = 3,834 makes the portfolio delta-gamma neutral, given the

other positions.
To examine the performance of this delta-gamma hedge, suppose the
stock price were to change to either $101 or to $99.

David

Stock
Price
99
100 10.3044
101 10.9285

K=100 Call
K=110 Call Portfolio
Pct. Chg.
Price
Price
Value
(S0 = 100)
9.6984 5.6310
$294,839
0.0007
6.0580
$294,837
6.5040
$294,841
0.0015

(Note how the value of the portfolio remains nearly unchanged, even when
the stock price changes up or down by 1%. )
At the same time, note that the portfolio delta of zero remains (virtually)
unchanged:
Original , @ S = 100 = (3834)(1) + (194)(100)(0.4365)
+ (-200)(100)(0.6151) = 0.10
@ S = 99, = (3834)(1) + (194)(100)(0.4178)
+ (-200)(100)(0.5967) = 5.32
@ S = 101, = (3834)(1) + (194)(100)(0.4552)
(100)(0.6330) = 4.88

+ (-200)

David