Understanding the Yield Curve

The yield curve is a favorite market indicator of analysts and investors around the world, but
what can it tell us? How can we use the yield curve to analyze current market conditions and
project future market conditions?

The yield curve can tell us a lot about what investors’ expectations for interest rates are and
whether they believe the economy is going to be expanding or contracting.

The Yield Curve

The yield curve is a graph that plots the relationship between yields to maturity and time to
maturity for a group of bonds. Along the x-axis of a yield-to-maturity graph, we see the time
to maturity for the associated bonds, and along the y-axis of the yield-to-maturity graph, we
see the yield to maturity for the associated bonds.

When you hear people talking about the yield curve, they are most likely talking about the
yield curve for U.S. Treasuries. However, virtually any group of bonds or other fixed-rate
securities that come from the same asset class and share the same credit quality can be plotted
on a yield curve. For this discussion, we will be referring to the yield curve for U.S.

Slope of the Yield Curve

The slope of the yield curve provides analysts and investors with the important information
they are looking for. Typically, you will see one of the following three slopes on your yield
curve:

– Normal yield curve

– Flat yield curve
– Inverted yield curve

Normal Yield Curve: A normal yield curve tells us that investors believe the Federal
Reserve is going to be raising interest rates in the future. Typically, the Federal Reserve only
has to raise interest rates when the economy is expanding and the Fed is worried about
inflation. Therefore, a normal yield curve often precedes an economic upturn.
Image of a Normal Yield Curve in relation to the S&P 500 on 17 March 2003—Chart
courtesy of StockCharts.com

Flat Yield Curve: A flat yield tells us that investors believe the Federal Reserve is going to
be cutting interest rates. Typically, the Federal Reserve only has to cut interest rates when the
economy is contracting and the Fed is trying to stimulate growth. Therefore, a flat yield curve
is often a sign of an economic slowdown.

Image of a Flat Yield Curve in relation to the S&P 500 on 9 March 2006—Chart courtesy
of StockCharts.com

Inverted Yield Curve: An inverted yield curve tells us that investors believe the Federal
Reserve is going to be dramatically cutting interest rates. Typically, the Federal Reserve has
to dramatically cut interest rates during a recession. Therefore, an inverted yield curve is
often a sign that the economy is in, or is headed for, a recession.
Image of an Inverted Yield Curve in relation to the S&P 500 on 31 January 2007—Chart
courtesy of StockCharts.com

This is the first part in a series about the most common questions in Market Risk interviews.
With this first part pertaining to VAR, we will eventually cover questions relating to yield
curves, products, and hedging.

Part two can be found here. Yield Curve

Part three can be found here. Quantitative concepts and hedging.

1. How would you calculate Value at Risk (VaR)?

Value at risk (VAR or sometimes VaR) has been called the “new science of risk
management”, but you do not need to be a scientist to use VAR. Here, in part 1 of this series,
we look at the idea behind VAR and the three basic methods of calculating it. In Part 2, we
apply these methods to calculating VAR for a single stock or investment.

The Idea behind VAR

The most popular and traditional measure of risk is volatility. The main problem with
volatility, however, is that it does not care about the direction of an investment’s movement:
a stock can be volatile because it suddenly jumps higher. Of course, investors are not
distressed by gains! (See The Limits and Uses of Volatility.)

For investors, risk is about the odds of losing money, and VAR is based on that common-
sense fact. By assuming investors care about the odds of a really big loss, VAR answers the
question, “What is my worst-case scenario?” or “How much could I lose in a really bad
month?”

Now let’s get specific. A VAR statistic has three components: a time period, a confidence
level and a loss amount (or loss percentage). Keep these three parts in mind as we give some
examples of variations of the question that VAR answers:

 What is the most I can – with a 95% or 99% level of confidence – expect to lose in dollars
over the next month?
  What is the maximum percentage I can – with 95% or 99% confidence – expect to lose over
the next year?

You can see how the “VAR question” has three elements: a relatively high level of
confidence (typically either 95% or 99%), a time period (a day, a month or a year) and an
estimate of investment loss (expressed either in dollar or percentage terms).

Methods of Calculating VAR

Institutional investors use VAR to evaluate portfolio risk, but in this introduction we will use
it to evaluate the risk of a single index that trades like a stock: the Nasdaq 100 Index, which
trades under the ticker QQQQ. The QQQQ is a very popular index of the largest non-
financial stocks that trade on the Nasdaq exchange.

There are three methods of calculating VAR: the historical method, the variance-covariance
method and the Monte Carlo simulation.

1. Historical Method
The historical method simply re-organizes actual historical returns, putting them in order
from worst to best. It then assumes that history will repeat itself, from a risk perspective.

The QQQ started trading in Mar 1999, and if we calculate each daily return, we produce a
rich data set of almost 1,400 points. Let’s put them in a histogram that compares the
frequency of return “buckets”. For example, at the highest point of the histogram (the highest
bar), there were more than 250 days when the daily return was between 0% and 1%. At the
far right, you can barely see a tiny bar at 13%; it represents the one single day (in Jan 2000)
within a period of five-plus years when the daily return for the QQQ was a stunning 12.4%!

With 95% confidence, we expect that our worst daily loss will not exceed 4%.Notice the red
bars that compose the “left tail” of the histogram. These are the lowest 5% of daily returns
(since the returns are ordered from left to right, the worst are always the “left tail”). The red
bars run from daily losses of 4% to 8%. Because these are the worst 5% of all daily returns,
we can say with 95% confidence that the worst daily loss will not exceed 4%. Put another
way, we expect with 95% confidence that our gain will exceed -4%. That is VAR in a
nutshell. Let’s re-phrase the statistic into both percentage and dollar terms:

 If we invest $100, we are 95% confident that our worst daily loss will not exceed $4 ($100 x -
4%).

You can see that VAR indeed allows for an outcome that is worse than a return of -4%. It
does not express absolute certainty but instead makes a probabilistic estimate. If we want to
increase our confidence, we need only to “move to the left” on the same histogram, to where
the first two red bars, at -8% and -7% represent the worst 1% of daily returns:

 With 99% confidence, we expect that the worst daily loss will not exceed 7%.
 Or, if we invest $100, we are 99% confident that our worst daily loss will not exceed $7.

2. What’s wrong with VaR as a measurement of risk?

 Given the calamity that has since occurred, there has been a great deal of talk, even in
quant circles, that this widespread institutional reliance on VaR was a terrible mistake.
At the very least, the risks that VaR measured did not include the biggest risk of all:
the possibility of a financial meltdown. “Risk modeling didn’t help as much as it
should have,” says Aaron Brown, a former risk manager at Morgan Stanley who now
works at AQR, a big quant-oriented hedge fund. A risk consultant named Marc Groz
says, “VaR is a very limited tool.” David Einhorn, who founded Greenlight Capital, a
prominent hedge fund, wrote not long ago that VaR was “relatively useless as a risk-
management tool and potentially catastrophic when its use creates a false sense of
security among senior managers and watchdogs. This is like an air bag that works all
the time, except when you have a car accident.” Nassim Nicholas Taleb, the best-
selling author of “The Black Swan,” has crusaded against VaR for more than a
decade. He calls it, flatly, “a fraud.”

VaR uses this normal distribution curve to plot the riskiness of a portfolio. But it
makes certain assumptions. VaR is often measured daily and rarely extends beyond a
few weeks, and because it is a very short-term measure, it assumes that tomorrow will
be more or less like today. Even what’s called “historical VaR” — a variation of
standard VaR that measures potential portfolio risk a year or two out, only uses the
previous few years as its benchmark. As the risk consultant Marc Groz puts it, “The
years 2005-2006,” which were the culmination of the housing bubble, “aren’t a very
good universe for predicting what happened in 2007-2008.

3. What is non-Linear VaR? How would you calculate it?

Nonlinear risk exposure arises in the VaR calculation of a portfolio of derivatives.

Nonlinear derivatives, such as options, depend on a variety of characteristics,
including implied volatility, time to maturity, underlying asset price and the current
interest rate. It is difficult to collect the historical data on the returns because the
option returns would need to be conditioned on all of the characteristics to use the
standard VaR approach. Inputting all of the characteristics associated with options
into the Black-Scholes model or another option pricing model causes the models to be
nonlinear.
 Therefore, the payoff curves, or the option premium as a function of the underlying
asset prices, are nonlinear. For example, suppose there is a change in the stock price
and it is input into the Black-Scholes model. The corresponding value is not
proportional to the input due to the time and volatility portion of the model, since
options are wasting assets.

The nonlinearity of derivatives leads to nonlinear risk exposures in the VaR of a

portfolio with nonlinear derivatives. Nonlinearity is easy to see in the payoff diagram
of the plain vanilla call option. The payoff diagram has a strong positive convex
payoff profile before the option’s expiration date, with respect to the stock price.
When the call option reaches a point where the option is in the money, it reaches a
point where the payoff becomes linear. Conversely, as a call option becomes
increasingly out of the money, the rate at which the option loses money decreases
until the option premium is zero.

4. What is the parametric method of calculating VaR? What are its advantages?

The parametric method, also known as the variance-covariance method, is a risk management
technique for calculating the value at risk of a portfolio of assets. The value at risk is a
statistical risk management technique measuring the maximum loss that an investment
portfolio is likely to face within a specified time frame with a certain degree of confidence.
The variance-covariance method to calculate the value at risk calculates the mean, or
expected value, and standard deviation of an investment portfolio.

The variance-covariance looks at the price movements of investments over a look-back

period and uses probability theory to compute a portfolio’s maximum loss. The variance-
covariance method for the value at risk calculates the standard deviation of price movements
of an investment or security. Assuming stock price returns and volatility follow a normal
distribution, the maximum loss within the specified confidence level is calculated.

For example, consider a portfolio that includes only one security, stock ABC. Suppose
$500,000 is invested in stock ABC. The standard deviation over 252 days, or one trading
year, of stock ABC is 7%. Following the normal distribution, the 95% confidence level has
a z-score of 1.645. The value at risk in this portfolio is $57,575 ($500000*1.645*.07).
Therefore, with 95% confidence, the maximum loss will not exceed $57,575 in a given
trading year.

The value at risk of a portfolio with two securities can be determined by first calculating the
portfolio’s volatility. Multiply the square of the first asset’s weight by the square of the first
asset’s standard deviation and add it to the square of the second asset’s weight multiplied by
the square of the second asset’s standard deviation. Add that value to two, multiplied by the
weights of the first and second assets by the correlation coefficient between the two assets,
multiplied by asset one’s standard deviation and asset two’s standard deviation. Then
multiply the square root of that value by the z-score and the portfolio value.

For example, suppose a risk manager wants to calculate the value at risk using the parametric
method for a one-day time horizon. The weight of the first asset is 40%, and the weight of the
second asset is 60%. The standard deviation is 4% for the first and 7% for the second asset.
The correlation coefficient between the two is 25%. The portfolio value is $50 million. The
parametric value at risk over a one-day period, with a 95% confidence level, is $3.99 million
($50000000*(-1.645)*√(0.4^2*0.04^2+0.6^2*0.07^2+2*0.4*0.6*0.04*0.07*0.25)).

If a portfolio has multiple assets, its volatility is calculated using a matrix. A variance-
covariance matrix is computed for all the assets. The vector of the weights of the assets in the
portfolio is multiplied by the transpose of the vector of the weights of the assets multiplied by
the covariance matrix of all of the assets.

5. What is the historical method of calculating VaR? What are its advantages?

The Historical Method, which I would call Historical Simulation requires that you have a
reasonably clean and accurate time series of data for the underlying asset. Essentially, you are
using the past performance of the asset to model its likely behaviour over a time frame of
typically 1 to 10 days. Choosing and updating your time series data set needs to be thought
about carefully as your VaR number can be impacted significantly by extreme events in the
time series used.

6. Why would you calculate VaR using Monte Carlo simulations?

Monte Carlo simulation is computationally a lot more expensive than Historical Simulation
or V-CV and requires that a large number of asset paths are calculated to get a statistically
significant result.

7. What’s GVAR? How can you calculate it?

Global Vector Auto-Regression (GVAR) model developed originally by Pesaran,

Schuermann and Weiner (2004). This model is applied for the Örst time to study the issue of
international trade adjustment. Two speciÖc characteristics of the model make it particularly
appealing for this issue, compared to the existing literature. The Örst one is that GVAR
models are speciÖcally designed to account for the interaction between a large number of
countries. This is a crucial feature given that global imbalances cannot be subsumed to one
country, or even to one country pair; rather, it involves a large number of countries, as
documented in Bracke et al. (2008). Having many countries allows to answer questions that
could not be tackled previously in studies with just three or four main countries/regions. For
instance, it provides estimates of the impact of a US slow-down not only on US imports, but
also on trade áows and output growth in European countries and in Asia. Such estimates
represent an important input in the debate on the possible “decoupling” of some regions of
the world. The second key feature of our model is that exports and imports are modelled
jointly, in contrast to the existing literature, which typically considers them separately. We
Önd that this innovation is important, given that exports and imports appear to comove
substantially for a variety of countries.Such comovement can derive in particular from the
strong import content of exports: with globalisa-tion and the internationalisation of
production, the production of exported goods and services tends to use a substantial amount
of imported components (as documented in Hummels, Ishii and Yi, 2001). This stylised fact
has important implications for the transmission of shocks across countries: if foreign demand
addressed to a given country falls, negatively impacting this countryís exports, its imports are
also likely to be a§ected, in turn impacting exports from other trading partners.

8. What do you know about extreme value theory?

Extreme value theory or extreme value analysis (EVA) is a branch of statistics dealing with
the extreme deviations from the median of probability distributions. It seeks to assess, from a
given ordered sample of a given random variable, the probability of events that are
more extremethan any previously observed.

9. What is Expected Shortfall? How is it calculated? Why is it considered better than

VaR? What are the disadvantages?

A measure that produces better incentives for traders than VAR is expected shortfall. This is
also sometimes referred to as conditional VAR, or tail loss. Where VAR asks the question
‘how bad can things get?’, expected shortfall asks ‘if things do get bad, what is our expected
loss?’.

Expected shortfall, like VAR, is a function of two parameters: N (the time horizon in days)
and X% (the confidence level). It is the expected loss during an N-day period, conditional
that the loss is greater than the Xth percentile of the loss distribution. For example, with X =
99 and N = 10, the expected shortfall is the average amount that is lost over a 10-day period,
assuming that the loss is greater than the 99th percentile of the loss distribution. Clearly, the
expected shortfall is much higher in figure 2 than figure.

10. What is expected shortfall?

Expected shortfall (ES) is a risk measure, a concept used in finance (and more specifically in
the field of financial risk measurement) to evaluate the market risk or credit risk of a
portfolio.

1. What are the uses of the yield curve?

The yield curve, a graph that depicts the relationship between bond yields and maturities, is
an important tool in fixed-income investing. Investors use the yield curve as a reference point
for forecasting interest rates, pricing bonds and creating strategies for boosting total returns.
The yield curve has also become a reliable leading indicator of economic activity.

There are two ways of looking at bond yields: current yield and yield to maturity.

• Current yield is the annual return earned on the price paid for a bond. It is calculated by
dividing the bond’s annual coupon interest payments by its purchase price. For example, if an
investor bought a bond with a coupon rate of 6% at par, and full face value of $1,000, the
interest payment over a year would be $60. That would produce a current yield of 6%
($60/$1,000). When a bond is purchased at full face value, the current yield is the same as the
coupon rate. However, if the same bond were purchased at less than face value, or at a
discount price, of $900, the current yield would be higher at 6.6% ($60/ $900).

 Yield to maturity reflects the total return an investor receives by holding the bond until it
matures. A bond’s yield to maturity reflects all of the interest payments from the time of
purchase until maturity, including interest on interest. Equally important, it also includes any
appreciation or depreciation in the price of the bond. Yield to call is calculated the same way
as yield to maturity, but assumes that a bond will be called, or repurchased by the issuer
before its maturity date, and that the investor will be paid face value on the call date.
http://faculty.baruch.cuny.edu/ryao/fin3710/PIMCO_YIELD_CURVE_PRIMER.pdf

2. What’s the riskiest part of the yield curve?

“The best value in the fixed income market right now is precisely where people have been
leaving, and that’s the long end of the yield curve,” said Jeff Rosenberg, BlackRock’s chief
investment strategist for fixed income. “What people have wrong is they think that the front
end of the yield curve is a safe place to hide out. But if the economy does what most people
expect, this is the riskiest part of the fixed income market.”What does it mean for risk when
the yield curve is inverted?

3. What does it mean for risk when the yield curve is inverted?

Historically, an inverted yield curve has been viewed as an indicator of a pending economic
recession. When short-term interest rates exceed long-term rates, market sentiment suggests
that the long-term outlook is poor and that the yields offered by long-term fixed income will
continue to fall. More recently, this viewpoint has been called into question, as foreign
purchases of securities issued by the U.S. Treasury have created a high and sustained level of
demand for products backed by U.S. government debt. When investors are aggressively
seeking debt instruments, the debtor can offer lower interest rates. When this occurs, many
argue that it is the laws of supply and demand, rather than impending economic doom and
gloom, that enable lenders to attract buyers without having to pay higher interest rates.

4. What is the discount factor? How would you calculate it?

Net present value is crucial for determining the time value of money when evaluating long-
term projects. Use net present value to help evaluate profit and losses in today’s dollars,
based on future payments. The key number needed to determine net present value is the
discount factor, the factor by which future monies received are multiplied to obtain net
present value.

Step 1

Determine the periodic interest rate in decimal form. This is found by dividing the annual
interest rate by the number of payments made per year. For example, if the annual interest is
6 percent and payments are made monthly, then the periodic interest rate is (.06/12) = .005.

Step 2

Find the total number of payments to be made. Let’s assume a company will pay off its debt
in three years. The number of payments would then be (3×12) = 36.

Step 3

Assign variables to each number. For example, P = periodic interest rate and n = number of
payments.

Step 4
Calculate the discount factor (D) using the formula D=1/(1+P)^n. Replace the variables with
your data. In the example above, the formula to find the discount factor would be
D=1/(1+.005)^36.

Step 5

Solve the equation. In our example, the result would be (1/1.1966)=0.8357.

5. What is convexity? How would you calculate it? Why is it important?

Convexity is a measure of the curvature or 2nd derivative of how the price of a bond varies
with interest rate, i.e. how the duration of a bond changes as the interest rate changes.
Specifically, one assumes that the interest rate is constant across the life of the bond and that
changes in interest rates occur evenly.

6. What’s the relationship between coupon rate and convexity?

The price sensitivity to parallel changes in the term structure of interest rates is highest with
a zero-coupon bond and lowest with an amortizing bond (where the payments are front-
loaded). Although the amortizing bond and the zero-coupon bond have different sensitivities
at the same maturity, if their final maturities differ so that they have identical bond
durations they will have identical sensitivities. That is, their prices will be affected equally by
small, first-order, (and parallel) yield curve shifts. They will, however, start to change by
different amounts with each further incremental parallel rate shift due to their differing
payment dates and amounts.

For two bonds with same par value, same coupon and same maturity, convexity may differ
depending on at what point on the price yield curve they are located.

Suppose both of them have at present the same price yield (p-y) combination; also you have
to take into consideration the profile, rating, etc. of the issuers: let us suppose they are issued
by different entities. Though both bonds have same p-y combination bond A may be located
on a more elastic segment of the p-y curve compared to bond B. This means if yield increases
further, price of bond A may fall drastically while price of bond B won’t change, i.e. bond B
holders are expecting a price rise any moment and are therefore reluctant to sell it off, while
bond A holders are expecting further price-fall and ready to dispose of it.

This means bond B has better rating than bond A.

So the higher the rating or credibility of the issuer the less the convexity and the less the gain
from risk-return game or strategies; less convexity means less price-volatility or risk; less risk
means less return.

7. What’s the meaning of duration? Is it constant for all yields?

The term duration has a special meaning in the context of bonds. It is a measurement of how
long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an
important measure for investors to consider, as bonds with higher durations carry more risk
and have higher price volatility than bonds with lower durations.
For each of the two basic types of bonds the duration is the following:
 1. Zero-Coupon Bond– Duration is equal to its time to maturity.2. Vanilla Bond– Duration will
always be less than its time to maturity.

Besides the movement of time and the payment of coupons, there are other factors that affect
a bond’s duration: the coupon rate and its yield. Bonds with high coupon rates and, in turn,
high yields will tend to have lower durations than bonds that pay low coupon rates or offer
low yields. This makes empirical sense, because when a bond pays a higher coupon rate or
has a high yield, the holder of the security receives repayment for the security at a faster rate.
The diagram below summarizes how duration changes with coupon rate and yield.

8. What’s the meaning of partial duration?

A duration measure calculated by changing one variable while all other variable are held
constant. The most common example Is key rate duration where all variables are held
constant except the yield for a specific maturity point on the yield curve. Another application
of partial duration is the calculation of option-adjusted duration by changing a variable such
the OAS while holding all other variables constant.

9. What are the limits of duration as a risk measure?

One of the limits of duration as a measure of interest rate/price sensitivity is that it is a linear
measure. That is, it assumes that for a certain percentage change in interest rate that an equal
percentage change in price will occur. However, as interest rates change, the price of a bond
is not likely to change linearly, but instead would change over some curved, or convex,
function of interest rates.

Questions on quantitative concepts:

1. Can you explain the assumptions behind Black Scholes?

First, there is an assumption that the stock doesn’t pay dividends during the option’s life.
Another assumption with the Black-Scholes Model for binary options and others is that the
European exercise terms are the ones that are used. American terms often allow the option to
be exercised during the life of the option, rather than only on the expiration date.

Another assumption with the Black-Scholes Model is that markets are efficient. This means
that people can’t predict with consistency what direction the market, or individual stocks, will
go. Another assumption for binary options with the Black-Scholes Model is that there is no
commission charged. While market participants usually do pay a commission, the assumption
with the Black-Scholes Model is that there won’t be one. Two final assumptions are that
interest rates will remain constant and known and that returns are normally distributed.

2. What’s a volatility smile? Why does it occur? What are the implications for Black
Scholes?

DEFINITION of ‘Volatility Smile‘ A common graphical shape that results from plotting the
strike price and implied volatility of a group of options with the same expiration date. The
volatility smile is so named because it looks like a person smiling.

In the Black–Scholes model, the theoretical value of a vanilla option is a monotonic

increasing function of the volatility of the underlying asset. This means it is usually possible
to compute a unique implied volatility from a given market price for an option. This implied
volatility is best regarded as a rescaling of option prices which makes comparisons between
different strikes, expirations, and underlyings easier and more intuitive.

When implied volatility is plotted against strike price, the resulting graph is typically
downward sloping for equity markets, or valley-shaped for currency markets. For markets
where the graph is downward sloping, such as for equity options, the term “volatility skew”
is often used. For other markets, such as FX options or equity index options, where the
typical graph turns up at either end, the more familiar term “volatility smile” is used. For
example, the implied volatility for upside (i.e. high strike) equity options is typically lower
than for at-the-money equity options. However, the implied volatilities of options on foreign
exchange contracts tend to rise in both the downside and upside directions. In equity markets,
a small tilted smile is often observed near the money as a kink in the general downward
sloping implicit volatility graph. Sometimes the term “smirk” is used to describe a skewed
smile.

3. What are the Greeks?

The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the
value of a portfolio to a small change in a given underlying parameter, so that component
risks may be treated in isolation, and the portfolio rebalanced accordingly to achieve a
desired exposure

4. How are the main Greeks derived?

First-order Greeks
Practical use Delta measures the rate of change of the theoretical option value with respect to
changes in the underlying asset’s price. Delta is the first derivative of the value of the option
with respect to the underlying instrument’s price.

For a vanilla option, delta will be a number between 0.0 and 1.0 for a long call (or a short
put) and 0.0 and −1.0 for a long put (or a short call); depending on price, a call option
behaves as if one owns 1 share of the underlying stock (if deep in the money), or owns
nothing (if far out of the money), or something in between, and conversely for a put option.
The difference of the delta of a call and the delta of a put at the same strike is close to but not
in general equal to one, but instead is equal to the inverse of the discount factor. By put–call
parity, long a call and short a put equals a forward F, which is linear in the spot S, with factor
the inverse of the discount factor, so the derivative dF/dS is this factor.

These numbers are commonly presented as a percentage of the total number of shares
represented by the option contract(s). This is convenient because the option will
(instantaneously) behave like the number of shares indicated by the delta. For example, if a
portfolio of 100 American call options on XYZ each have a delta of 0.25 (=25%), it will gain
or lose value just like 25 shares of XYZ as the price changes for small price movements. The
sign and percentage are often dropped – the sign is implicit in the option type (negative for
put, positive for call) and the percentage is understood. The most commonly quoted are 25
delta put, 50 delta put/50 delta call, and 25 delta call. 50 Delta put and 50 Delta call are not
quite identical, due to spot and forward differing by the discount factor, but they are often
conflated.

Delta is always positive for long calls and negative for long puts (unless they are zero). The
total delta of a complex portfolio of positions on the same underlying asset can be calculated
by simply taking the sum of the deltas for each individual position – delta of a portfolio is
linear in the constituents. Since the delta of underlying asset is always 1.0, the trader
could delta-hedge his entire position in the underlying by buying or shorting the number of
shares indicated by the total delta. For example, if the delta of a portfolio of options in XYZ
(expressed as shares of the underlying) is +2.75, the trader would be able to delta-hedge the
portfolio by selling short 2.75 shares of the underlying. This portfolio will then retain its total
value regardless of which direction the price of XYZ moves. (Albeit for only small
movements of the underlying, a short amount of time and not-withstanding changes in other
market conditions such as volatility and the rate of return for a risk-free investment).

The (absolute value of) Delta is close to, but not identical with, the percent moneyness of an
option, i.e., the implied probability that the option will expire in-the-money (if the market
moves under Brownian motion in the risk-neutral measure).[5] For this reason some option
traders use the absolute value of delta as an approximation for percent moneyness. For
example, if an out-of-the-money call option has a delta of 0.15, the trader might estimate that
the option has approximately a 15% chance of expiring in-the-money. Similarly, if a put
contract has a delta of −0.25, the trader might expect the option to have a 25% probability of
expiring in-the-money. At-the-money puts and calls have a delta of approximately 0.5 and
−0.5 respectively with a slight bias towards higher deltas for ATM calls,[note 1] i.e. both have
approximately a 50% chance of expiring in-the-money. The correct, exact calculation for the
probability of an option finishing at a particular price of K is its Dual Delta, which is the first
derivative of option price with respect to strike.[citation needed]

Given a European call and put option for the same underlying, strike price and time to
maturity, and with no dividend yield, the sum of the absolute values of the delta of each
option will be 1 – more precisely, the delta of the call (positive) minus the delta of the put
(negative) equals 1. This is due to put–call parity: a long call plus a short put (a call minus a
put) replicates a forward, which has delta equal to 1.

If the value of delta for an option is known, one can calculate the value of the delta of the
option of the same strike price, underlying and maturity but opposite right by subtracting 1
from a known call delta or adding 1 to a known put delta.

d(call) − d(put) = 1, therefore: d(call) = d(put) + 1 and d(put) = d(call) − 1.

For example, if the delta of a call is 0.42 then one can compute the delta of the corresponding
put at the same strike price by 0.42 − 1 = −0.58. To derive the delta of a call from a put, one
can similarly take −0.58 and add 1 to get 0.42.

Vega is not the name of any Greek letter. However, the glyph used is the Greek letter nu ( ).
Presumably the name vega was adopted because the Greek letter nu looked like a Latin vee,
and vega was derived from vee by analogy with how beta, eta, andtheta are pronounced in
American English. Another possibility is that it is named after Joseph De La Vega, famous
for Confusion of Confusions, a book about stock markets and which discusses trading
operations that were complex, involving both options and forward trades.[6]

The symbol kappa, , is sometimes used (by academics) instead of vega (as is tau ( ) or
capital Lambda ( ),[7]:315 though these are rare).

Vega is typically expressed as the amount of money per underlying share that the option’s
value will gain or lose as volatility rises or falls by 1%.

Vega can be an important Greek to monitor for an option trader, especially in volatile
markets, since the value of some option strategies can be particularly sensitive to changes in
volatility. The value of an option straddle, for example, is extremely dependent on changes to
volatility.
The mathematical result of the formula for theta (see below) is expressed in value per year.
By convention, it is usual to divide the result by the number of days in a year, to arrive at the
amount of money per share of the underlying that the option loses in one day. Theta is almost
always negative for long calls and puts and positive for short (or written) calls and puts. An
exception is a deep in-the-money European put. The total theta for a portfolio of options can
be determined by summing the thetas for each individual position.Theta measures the
sensitivity of the value of the derivative to the passage of time (see Option time value): the
“time decay.”

The value of an option can be analysed into two parts: the intrinsic value and the time value.
The intrinsic value is the amount of money you would gain if you exercised the option
immediately, so a call with strike $50 on a stock with price $60 would have intrinsic value of
$10, whereas the corresponding put would have zero intrinsic value. The time value is the
value of having the option of waiting longer before deciding to exercise. Even a deeply out of
the money put will be worth something, as there is some chance the stock price will fall
below the strike before the expiry date. However, as time approaches maturity, there is less
chance of this happening, so the time value of an option is decreasing with time. Thus if you
are long an option you are short theta: your portfolio will lose value with the passage of time
(all other factors held constant).

Rho measures sensitivity to the interest rate: it is the derivative of the option value with
respect to the risk free interest rate (for the relevant outstanding term).

Except under extreme circumstances, the value of an option is less sensitive to changes in the
risk free interest rate than to changes in other parameters. For this reason, rho is the least used
of the first-order Greeks.
Rho is typically expressed as the amount of money, per share of the underlying, that the value
of the option will gain or lose as the risk free interest rate rises or falls by 1.0% per annum
(100 basis points).

Second-order Greeks Lambda, omega, or elasticity[4] is the percentage change in option

value per percentage change in the underlying price, a measure of leverage, sometimes called
gearing.
Long option Delta, underlying price, and Gamma. Gamma, measures the rate of change in the
delta with respect to changes in the underlying price. Gamma is the second derivative of the
value function with respect to the underlying price. All long options have positive gamma
and all short options have negative gamma. Long options have a positive relationship with
Gamma because as price increases, Gamma increases up as well, causing Delta to approach 1
from 0 (long call option) and 0 from -1 (long put option). The inverse is true for short
options.[8]

Gamma is greatest approximately at-the-money (ATM) and diminishes the further out you go
either in-the-money (ITM) or out-of-the-money (OTM). Gamma is important because it
corrects for the convexity of value.

When a trader seeks to establish an effective delta-hedge for a portfolio, the trader may also
seek to neutralize the portfolio’s gamma, as this will ensure that the hedge will be effective
over a wider range of underlying price movements. However, in neutralizing the gamma of a
portfolio, alpha (the return in excess of the risk-free rate) is reduced.

4. What is delta hedging?

An options strategy that aims to reduce (hedge) the risk associated with price movements in
the underlying asset by offsetting long and short positions. For example, a long call position
may be delta hedged by shorting the underlying stock.

5. When can hedging an options position mean that you take on more risk?

Hedging can increase your risk if you are forced to both buy short-dated options and hedge
them

E.g. on Monday you get forced to buy some Friday expiry OTM puts, say 95% strike S&P
weeklies. Of course, you go and buy some delta against them to “hedge” yourself. Next thing
you know, the the market tanks. Unfortunately, by Friday it’s only down 3.5%, so it’s does
not fall far enough to reach the strike. So, on Friday expiration, you are out your premium
and down money on your delta.

6. What is interest rate risk?

Interest rate risk is the risk that arises for bond owners from fluctuatinginterest rates. How
much interest rate risk a bond has depends on how sensitive its price is to interest
rate changes in the market. The sensitivity depends on two things, the bond’s time to
maturity, and the coupon rate of the bond.

7. What is reinvestment risk?

Reinvestment risk is the risk that the proceeds from the payment of principal and interest,
which have to be reinvested at a lower rate than the original investment. Call features affect
an investor’s reinvestment riskbecause corporations typically call their bonds in a declining
interest rate environment.

8. How do interest rate risk and reinvestment risk interact?

What if interest rates go down instead? The price of a fixed-rate bond will rise and entice
some holders to sell the bond for a profit. But others will hold onto the bond and will find that
they cannot make as much interest income from reinvesting the periodic coupon payments
they receive. This is reinvestment risk — if interest rates go down, your interest on interest
will decline. This lowers a bond’s yield to maturity, which is a function of the total income,
including reinvested interest income, which will be provided by the bond.

9. What are the risks inherent in an interest rate swap?

What are the risks inherent in an interest rate

swap?