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811 Advanced Risk Analytics

Week 3: How traders manage their risks

 How traders manage their risks?

Chapter 8

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A Trader’s Gold Portfolio. How Should Risks Be
Hedged?

Position Value ($)

Spot Gold 3,180,000
Forward Contracts – 3,060,000
Futures Contracts 2,000
Swaps 180,000
Options – 6,110,000
Exotics 125,000
Total −5,683,000

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 Delta
• Delta of a portfolio is the partial derivative of portfolio value
(P) with respect to the price of the underlying asset (𝑆) (gold in
this case)
𝜕P
Δ𝑝 =
𝜕𝑆
• Suppose that a $0.1 increase in the price of gold leads to the
gold portfolio decreasing in value by $100
• The delta of the portfolio is −1000
• The portfolio could be hedged against short-term changes in
the price of gold by buying 1000 ounces of gold. This is known
as making the portfolio delta neutral

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 Linear vs Nonlinear Products
• When the price of a product is linearly dependent on
the price of an underlying asset a “hedge and forget’’
strategy can be used
• Non-linear products require the hedge to be
rebalanced to preserve delta neutrality

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Linear Products

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 Example of Hedging a Nonlinear
Product
• A bank has sold for $300,000 a European call
option on 100,000 shares of a nondividend paying
stock
• S0 = 49, K = 50, r = 5%, s = 20%, T = 20 weeks,
m = 13%
• The Black-Scholes-Merton value of the option is
$240,000
• How does the bank hedge its risk?

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Example of Hedging a Nonlinear Product

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Example of Hedging a Nonlinear Product

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 Delta of the option
• Delta (D) is the rate of change of the option
price with respect to the underlying stock
• Delta (D) is a partial derivative of option price
with regards to its underlying stock price
Option Price (𝑓)

𝜕𝑓
Slope = D=
B 𝜕𝑆

A Stock price (𝑆)

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 Delta Hedging
• Initially the delta of the option is 0.522
• The delta of the position is -52,200
• This means that 52,200 shares must purchased to
create a delta neutral position
• But, if a week later delta falls to 0.458, 6,400
shares must be sold to maintain delta neutrality

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 Where the Costs Come From
• Delta hedging a short option position tends to involve
selling after a price decline and buying after a price
increase
• This is a “sell low, buy high” strategy.
• The total costs incurred are close to the theoretical
price of the option

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 Gamma
• Gamma (G) is the rate of change of delta (D) with
respect to the price of the underlying asset
𝜕Δ 𝜕 2 𝑃
Γ= = 2
𝜕𝑆 𝜕𝑆
• Gamma is greatest for options that are close to the
money

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 Gamma

• G addresses Delta hedging errors due to Curvature.

• If magnitude of Γ is small, Δ is less sensitive to price of
underlying asset. Rebalancing to make delta neutral
portfolio is relatively infrequent.
• If magnitude of Γ is large, Δ is very sensitive to price of
underlying asset. Rebalancing needs to be frequent.

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Gamma Measures the Delta Hedging Errors
Caused By Curvature

Call
price

C''
C'

C
Stock price
S S'
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 Delta and Gamma neutrality: Example
The following options are available on ENZCO stock:
Type K T Delta Gamma
Call $50 1.0 0.627 0.0336
Put $50 0.75 -0.389 0.0383

S = $50, s = 25% and r = 5%

BSOPM values call at $6.17, put at $3.37
Assume an options trader sells one ENZCO call option.
(a) What position must she take in the stock to make her portfolio
delta-neutral?
(b) What position must she take in the stock and put to make her
portfolio delta-neutral and gamma-neutral?
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 Hedging for price risk (Delta hedging)

Gamma, Delta and the position in the Options

Long call Short call Long put Short put

Delta Positive Negative Negative Positive

Gamma Positive Negative Positive Negative

• Formulas to calculate Delta and Gamma is for the Long position of

option.
• Hence the values of Greek letters provided are shown with the sign
consistent with Long position.

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Trader sells 1 call, so:
Δ𝑐𝑎𝑙𝑙 = −0.627
Γ𝑐𝑎𝑙𝑙 = −0.0336
(a) Let say we take a position on ns stocks, note that Δ𝑠𝑡𝑜𝑐𝑘 = 1.
Δ𝑝𝑜𝑟𝑡 = 𝑛𝑐𝑎𝑙𝑙 × Δ𝑐𝑎𝑙𝑙 + 𝑛𝑠 × Δ𝑠𝑡𝑜𝑐𝑘

Δ𝑝𝑜𝑟𝑡 = 1 × (−0.627) + 𝑛𝑠 × 1

To make portfolio delta-neutral, we need Δ𝑝𝑜𝑟𝑡 = 0, so

− 0.627 + 𝑛𝑠 = 0, or 𝑛𝑠 = 0.627
We need to long 0.627 stocks.

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 Hedging for price risk (Delta hedging)

Summary of Delta Hedging

Long call Short call Long put Short put

Delta Short Δcall Long Δcall Long Δput Short Δput
Hedging stocks stocks stocks stocks

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(b) Let say we take positions on ns stocks, and np puts. Note that
note that Δ𝑠𝑡𝑜𝑐𝑘 = 1, Γ𝑠𝑡𝑜𝑐𝑘 = 0.
Δ𝑝𝑜𝑟𝑡 = 𝑛𝑐𝑎𝑙𝑙 × Δ𝑐𝑎𝑙𝑙 + 𝑛𝑠 × Δ𝑠𝑡𝑜𝑐𝑘 + 𝑛𝑝 × Δ𝑝𝑢𝑡
൝
Γ𝑝𝑜𝑟𝑡 = 𝑛𝑐𝑎𝑙𝑙 × Γ𝑐𝑎𝑙𝑙 + 𝑛𝑠 × Γ𝑠𝑡𝑜𝑐𝑘 + 𝑛𝑝 × Γ𝑝𝑢𝑡

Δ𝑝𝑜𝑟𝑡 = 1 × (−0.627) + 𝑛𝑠 × (1) + 𝑛𝑝 × (−0.389)

൝
Γ𝑝𝑜𝑟𝑡 = 1 × (−0.0336) + 𝑛𝑠 × (0) + 𝑛𝑝 × (0.0383)

Δ𝑝𝑜𝑟𝑡 = −0.627 + 𝑛𝑠 + 𝑛𝑝 × −0.389 = 0

൝
Γ𝑝𝑜𝑟𝑡 = −0.0336 + 𝑛𝑝 × 0.0383 = 0

From Gamma-neutral we have 𝑛𝑝 =0.8773 puts. Replace in the

Delta-neutral equation we have 𝑛𝑠 = 0.968 stocks.
→ Buy 0.968 stocks and 0.8773 puts.
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 Vega
• Vega (n) is the rate of change of the value of a portfolio
with respect to volatility (𝜎)
𝜕𝑃
𝜈=
𝜕𝜎
• If the magnitude of vega is large, the portfolio’s value is
very sensitive to a small change in volatility.
• If the magnitude of vega is close to zero, volatility
changes have very limited impact on the portfolio’s value
• Like gamma, vega tends to be greatest for options that
are close to the money

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 Gamma and Vega neutrality: Example
Consider a portfolio dependent on the price of a single asset
that is delta neutral, with a gamma of -5,000 and a vega of -
8,000. The options shown below can be traded
Delta Gamma Vega
Portfolio 0 -5,000 -8,000
Option 1 0.6 0.5 2.0
Option 2 0.5 0.8 1.2

a) How to make the portfolio gamma neutral?

b) How to make the portfolio both gamma and vega neutral?
c) After (b), how to make portfolio delta neutral again?

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 Gamma and Vega neutrality: Example
a) How to make the portfolio gamma neutral?
Can use either Option to make Gamma neutral. E.g., if we use
Option 1:
Γ𝑎𝑙𝑙 = Γ𝑝 + 𝑤1 Γ1 = 0
−5,000 + 𝑤1 0.5 = 0
5,000
So, 𝑤1 = = 10,000
0.5

We need to include 10,000 Option 1 to make Gamma neutral

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 Gamma and Vega neutrality: Example
b) How to make the portfolio gamma and vega neutral?
Need to use both Options
Γ𝑎𝑙𝑙 = −5,000 + 𝑤1 0.5 + 𝑤2 0.8 = 0
ቊ
𝑣𝑎𝑙𝑙 = −8,000 + 𝑤1 2 + 𝑤2 1.2 = 0
Solve this system, we have 𝑤1 = 400, and 𝑤2 = 6,000
We need to include 400 Option 1 and 6,000 Option 2 to make the
portfolio gamma and vega neutral

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 Gamma and Vega neutrality: Example
c) How to make the portfolio delta neutral again after (b)?
The Delta of the portfolio after including 400 Option 1 and
6,000 Option 2 is:
400 × 0.6 + 6,000 × 0.5 = 3,240
Therefore, 3,240 units of the underlying asset need to be sold to
maintain the delta neutrality

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 Gamma and Vega Limits
• In practice, a traders must keep gamma and vega
within limits set by risk management

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 Theta
 Theta (Q) of a portfolio is the rate of change of the
portfolio’s value (𝑃) with respect to the passage of time
(𝑡)
𝜕𝑃
Θ=
𝜕𝑡
 The theta of a call or put is usually negative. This means
that, if time passes with all else remaining the same,
option tends to be less valuable.
 Θ is normally quoted with time measured in day. E.g., Θ =
-0.012 per calendar day, meaning, portfolio value
decreases by 0.012 when 1 calendar day passes.
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27
 Theta
• It makes sense to hedge against the changes or
volatility of the underlying asset, but it does not
make sense to hedge against the effect of the
passage of time on an option portfolio
• But Theta can be considered as a useful descriptive
statistic for a portfolio
• In delta neutral portfolio, if theta is large and
positive, gamma tends to be large and negative, and
vice versa

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 Taylor Series Expansion (TSE)
• The TSE can be used to show how the change in the
portfolio value in a short period of time depends on the
Greek letters
• If the volatility of the underlying asset is assumed to be
constant, P is a function of S, and t, then:

𝜕𝑃 𝜕𝑃 1 𝜕2𝑃 2+
1 𝜕 2𝑃
2+
𝜕 2𝑃
Δ𝑃 = Δ𝑆 + Δ𝑡 + 2 (Δ𝑆) 2 (Δ𝑡) Δ𝑆Δ𝑡 + ⋯
𝜕𝑆 𝜕𝑡 2 𝜕𝑆 2 𝜕𝑡 𝜕𝑆𝜕𝑡

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 Interpretation of Gamma
• For a delta neutral portfolio, therefore:
DP  Q Dt + ½GDS 2

DP DP

DS
DS

Positive Gamma Negative Gamma

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 Rho
• Rho is the rate of change of the value of a portfolio with
respect to the interest rate
𝜕𝑃
𝑅ℎ𝑜 =
𝜕𝑟
• If the magnitude of Rho is large, the portfolio’s value is
very sensitive to a small change in interest rate.
• If the magnitude of Rho is close to zero, interest rate
changes have very limited impact on the portfolio’s value

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Taylor Series Expansion when Volatility is
Uncertain

𝜕𝑃 𝜕𝑃 𝜕𝑃 1 𝜕2𝑃 2
1 𝜕 2𝑃
2
Δ𝑃 = Δ𝑆 + Δ𝜎 + Δ𝑡 + 2
(Δ𝑆) + 2
(Δ𝜎) +⋯
𝜕𝑆 𝜕𝜎 𝜕𝑡 2 𝜕𝑆 2 𝜕𝜎

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 Summary
• Delta (D) measures the sensitivity of the portfolio value to a
𝜕𝑃
change in the price of the underlying asset, D= .
𝜕𝑆

• Gamma (G) measures the sensitivity of the Delta (D) to a

𝜕Δ 𝜕2 𝑃
change in the price of the underlying asset, Γ = = .
𝜕𝑆 𝜕𝑆 2

• Theta (Q) measures the sensitivity of the portfolio value when

𝜕𝑃
time passes, Θ = .
𝜕𝑡

• Vega (n) measures the sensitivity of the portfolio value to a

𝜕𝑃
change in the volatility of the underlying asset, 𝜈 = .
𝜕𝜎

• Rho measures the sensitivity of the portfolio value to a change

𝜕𝑃
in the interest rate, 𝑅ℎ𝑜 = .
𝜕𝑟
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. 33
 Managing Delta, Gamma, & Vega

• D can be changed by taking a position in the

underlying
• To adjust G & n it is necessary to take a position in an
option or other derivative

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 Hedging in Practice
• Traders usually ensure that their portfolios are delta-
neutral at least once a day
• Whenever the opportunity arises, they improve
gamma and vega
• As portfolio becomes larger hedging becomes less
expensive

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 Practice Questions and Problems
8.1 The delta of a derivatives portfolio dependent on an
index is -2,100. The index is currently 1,000. Estimate
what happens to the value of the portfolio when the
index increases to 1,005

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 Practice Questions and Problems
8.1 The delta of a derivatives portfolio dependent on an
index is -2,100. The index is currently 1,000. Estimate
what happens to the value of the portfolio when the
index increases to 1,005

𝜕P
Δ𝑝 = = −2,100
𝜕𝑆

→ 𝜕P = −2,100 × 𝜕𝑆 = −2,100 × 5 = −$10,500

So, value of the portfolio decreases by $10,500.

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 Practice Questions and Problems
8.2 The vega of a derivatives portfolio dependent on
the dollar-sterling exchange rate is 200 (per %).
Estimate the effect on the portfolio of an increase in
the volatility of the exchange rate from 12% to 14%

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 Practice Questions and Problems
8.2 The vega of a derivatives portfolio dependent on
the dollar-sterling exchange rate is 200 (per %).
Estimate the effect on the portfolio of an increase in
the volatility of the exchange rate from 12% to 14%

𝜕𝑃
𝜈= = 200 → 𝜕𝑃 = 200 × 𝜕𝜎 = 200 × 2 = $400
𝜕𝜎

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 Practice Questions and Problems
8.3 The gamma of a delta-neutral portfolio is 30.
Estimate what happens to the value of the portfolio
when the price of the underlying asset
(a) Suddenly increases by $2, and
(b) Suddenly decreases by $2

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 Practice Questions and Problems
8.3 The gamma of a delta-neutral portfolio is 30.
Estimate what happens to the value of the portfolio
when the price of the underlying asset
(a) Suddenly increases by $2
Using TSE: DP  Q Dt + ½GDS 2 = 0.5x30x22 = $60

Another approximation:
𝜕2𝑃 2 2
$120
Γ = 2 = 30 → 𝜕 𝑃 = 30 × 2 = $120 → 𝜕𝑃~ = $60
𝜕𝑆 2
(b) Suddenly decreases by $2: same with (a)

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 Practice Questions and Problems
8.9 A bank’s position in options on the dollar-euro exchange rate
has a delta of 30,000 and a gamma of -80,000. Explain how
these numbers can be interpreted. The exchange rate (dollars
per euro) is 0.9.
(i) What position would you take to make the position delta
neutral?
(ii) After a short period of time, the exchange rate moves to
0.93. Estimate the new delta. What additional trade is
necessary to keep the position delta neutral.
(iii) Assuming the bank did set up a delta-neutral position
originally, has it gained or lost money from the exchange-
rate movement?

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 Practice Questions and Problems
8.9 A bank’s position in options on the dollar-euro exchange rate
has a delta of 30,000 and a gamma of -80,000. Explain how
these numbers can be interpreted. The exchange rate (dollars
per euro) is 0.9.
(i) What position would you take to make the position delta
neutral?
Δp = 30,000 > 0 → to make delta neutral, we need to short Δ
units of underlying asset.
In this case, we need to short (or sell) 30,000 Euros

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 Practice Questions and Problems
(ii) After a short period of time, the exchange rate moves to 0.93.
Estimate the new delta. What additional trade is necessary to
keep the position delta neutral.

𝜕Δ
Γ= → 𝜕Δ = 𝜕𝑆 × Γ = 0.93 − 0.9 × −80,000 = −2,400
𝜕𝑆
This means, Delta decreases by 2,400. Therefore, new Delta is:
30,000 – 2,400 = 27,600
To keep Delta neutral the bank needs to unwind its short
position by 2,400 Euros. This would ensure the net short position
is 27,600 Euros.

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 Practice Questions and Problems
(iii) Assuming the bank did set up a delta-neutral position
originally, has it gained or lost money from the exchange-rate
movement?
When a portfolio is Delta-neutral and negative Gamma, the bank
is likely to experience a loss if there is a large movement from
the exchange-rate. (similar to problem 8.3) Note that,
𝜕2𝑃
Γ=
𝜕𝑆 2

If Γ < 0 and since 𝜕𝑆 2 > 0 (always), if movement in underlying

asset price (𝜕𝑆) is large, 𝜕𝑃 will be negative and large.

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 Own Practice Questions (solution given)
8.17 A financial institution has the following portfolio of options on
sterling:
Type Position Delta Gamma Vega
Call -1,000 0.5 2.2 1.8
Call -500 0.8 0.6 0.2
Put -2,000 -0.4 1.3 0.7
Call -500 0.7 1.8 1.4

A traded option is available with a delta of 0.6, a gamma of 1.5, and a

vega of 0.8.
a) What position in the traded option and in sterling would make the
portfolio both gamma neutral and delta neutral?
b) What position in the traded option and in sterling would make the
portfolio both vega neutral and delta neutral?
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 Own Practice Questions (solution given)
8.18 Consider again the situation in Problem 8.17. Suppose that
a second traded option with a delta of 0.1, a gamma of 0.5,
and a vega of 0.6 is available. How could the portfolio be made
delta, gamma, and vega neutral?

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