P&L Attribution and Risk Management

Liuren Wu

Options Markets

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 1 / 20
Outline

1 P&L attribution via the BSM model

2 Delta

3 Vega

4 Gamma

5 Static hedging

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 2 / 20
P&L attribution

If we own a portfolio of European options at the same maturity, we know

how to construct the payoff function of the portfolio at expiry.
Before the option expires, the option prices vary as the underlying price
changes and as volatility changes.
For risk management, it is important to know as the underlying price goes
up or down by 1%, or as the underlying return volatility goes up or down by
1%, how much the portfolio value will change.
If the portfolio value can vary a lot (the portfolio is very risky, volatile), risk
managers must propose ways to reduce the risk, either by
reducing/unloading positions, or by hedging.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 3 / 20
P&L attribution via the BSM model
The common practice is to analyze and manage the options risk via the
BSM pricing relation, B(t, St , It ).
B denotes the BSM pricing formula (for an option at K , T )).
The option value vary over time due to variations in calendar time (t),
underlying security price (St ), the implied volatility of the option (It ).
How calendar time moves forward is known; but the variation of St and
It in the future is unknown and must be managed.
One can perform a Taylor expansion of the option value change over a short
time interval (say one day):
∆Bt ∂Bt ∂Bt ∂Bt
∆t = ∂t ∆t + ∂St ∆St + ∂It ∆It
2 2
1 ∂2B
+ 21 ∂∂SB2 (∆St )2 + ∂S∂ t ∂I
B
t
(∆St )(∆It ) + 2 ∂It2 (∆It )
2
t

The partial derivatives capture (risk) exposures to time decay ( ∂B∂t ,

t

∂Bt ∂Bt
theta), price movement ( ∂St , delta), volatility movement ( ∂It , vega),
2
∂2B ∂2B
second-order effects ( ∂∂SB2 , gamma; ∂St ∂It , vanna; ∂It2
, volga)
t

They are often referred to as option greeks.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 4 / 20
Risk management via BSM greeks
∆Bt ∂Bt ∂Bt ∂Bt
∆t = ∂t ∆t + ∂St ∆St + ∂It ∆It
2 2
1 ∂2B
+ 12 ∂∂SB2 (∆St )2 + ∂S∂ t ∂I
B
t
(∆St )(∆It ) + 2 ∂It2 (∆It )
2
t

If we can estimate all the greeks (risk exposures) of an option (portfolio), we

would know how much the portfolio value can change if some risk changes
by a certain amount.
If we form a portfolio that cancels out all risk exposures, the portfolio value
will not vary much no matter what varies — This is a very safe portfolio.
If we have a stock option portfolio with a delta of 1bn, it means that the
portfolio can lose by $1bn dollars if the stock price goes down by $1.
The risk manager can remove this risk by selling 1bn share of the stock.
If the portfolio has a delta exposure of –1bn, it means that the portfolio can
lose by $1bn dollars if the security price goes up by $1.
If the portfolio has a vega exposure of –1bn, the portfolio can lose
$10million if the volatility goes up by 0.01 (or one percentage point).

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 5 / 20
The BSM Delta
The BSM delta of European options (Can you derive them?):
∂ct ∂pt
∆c ≡ = e −qτ N(d1 ), ∆p ≡ = −e −qτ N(−d1 )
∂St ∂St
(St = 100, T − t = 1, σ = 20%)
BSM delta Industry delta quotes
1 100
call delta call delta
0.8 put delta 90 put delta

0.6 80

0.4 70

0.2 60
Delta

Delta
0 50

−0.2 40

−0.4 30

−0.6 20

−0.8 10

−1 0
60 80 100 120 140 160 180 60 80 100 120 140 160 180
Strike Strike

Industry quotes the delta in absolute percentage terms (right panel).

Which of the following is out-of-the-money? (i) 25-delta call, (ii) 25-delta
put, (iii) 75-delta call, (iv) 75-delta put.
The strike of a 25-delta call is close to the strike of: (i) 25-delta put, (ii)
50-delta put, (iii) 75-delta put.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 6 / 20
Delta as a moneyness measure
Different ways of measuring moneyness:
K (relative to S or F ): Raw measure, not comparable across different stocks.
K /F : better scaling than K − F .
ln K /F : more symmetric under BSM.
ln K /F
√ : standardized by volatility and option maturity, comparable across
σ (T −t)
stocks. Need to decide what σ to use (ATMV, IV, 1).
d1 : a standardized variable.
d2 : Under BSM, this variable is the truly standardized normal variable with
φ(0, 1) under the risk-neutral measure.
delta: Used frequently in the industry, quoted in absolute percentages.
Measures moneyness: Approximately the percentage chance the option
will be in the money at expiry.
Reveals your underlying exposure (how many shares needed to achieve
delta-neutral).
Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 7 / 20
Delta hedging

Example: A bank has sold for $300,000 a European call option on 100,000
shares of a nondividend paying stock, with the following information:
St = 49, K = 50, r = 5%, σ = 20%, (T − t) = 20weeks, µ = 13%.
What’s the BSM value for the option? → $2.4
What’s the BSM delta for the option? → 0.5216.
Delta hedging: Buy 52,000 share of the underlying stock now. Adjust the
shares over time to maintain a delta-neutral portfolio.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 8 / 20
Delta hedging with futures

The delta of a futures contract is e (r −q)(T −t) .

The delta of the option with respect to (wrt) futures is the delta of the
option over the delta of the futures.
The delta of the option wrt futures (of the same maturity) is
∂ct ∂ct /∂St
∆c/F ≡ ∂Ft,T = ∂Ft,T /∂St = e −r τ N(d1 ),
∂pt ∂pt /∂St
∆p/F ≡ ∂Ft,T = ∂Ft,T /∂St = −e −r τ N(−d1 ).

Whenever available (such as on indexes, commodities), using futures to

delta hedge can potentially reduce transaction costs.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 9 / 20
OTC quoting and trading conventions for currency options

Options are quoted at fixed time-to-maturity (not fixed expiry date).

Options at each maturity are not quoted in invoice prices (dollars), but in
the following format:
Delta-neutral straddle implied volatility (ATMV):
A straddle is a portfolio of a call & a put at the same strike. The strike
here is set to make the portfolio delta-neutral ⇒ d1 = 0.
25-delta risk reversal: RR25 = IV (∆c = 25) − IV (∆p = 25).
25-delta butterfly spreads:
BF25 = (IV (∆c = 25) + IV (∆p = 25))/2 − ATMV .
Risk reversals and butterfly spreads at other deltas, e.g., 10-delta.
When trading, invoice prices and strikes are calculated based on the BSM
formula.
The two parties exchange both the option and the underlying delta.
The trades are delta-neutral.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 10 / 20
The BSM vega

Vega (ν) is the rate of change of the value of a derivatives portfolio with
respect to volatility — it is a measure of the volatility exposure.
BSM vega: the same for call and put options of the same maturity
∂ct ∂pt √
ν≡ = = St e −q(T −t) T − tn(d1 )
∂σ ∂σ
x 2
n(d1 ) is the standard normal probability density: n(x) = √1 e − 2 .
2π

40
(St = 100, T − t = 1, σ = 20%) 40

35 35

30 30

25 Vega 25
Vega

20 20

15 15

10 10

5 5

0 0
60 80 100 120 140 160 180 −3 −2 −1 0 1 2 3
Strike d2

Volatility exposure (vega) is higher for at-the-money options.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 11 / 20
Vega hedging

Delta can be changed by taking a position in the underlying.

To adjust the volatility exposure (vega), it is necessary to take a position in
an option or other derivatives.
Hedging in practice:
Traders usually ensure that their portfolios are delta-neutral at least
once a day.
Whenever the opportunity arises, they improve/manage their vega
exposure — options trading is more expensive.
As portfolio becomes larger, hedging becomes less expensive.
Under the assumption of BSM, vega hedging is not necessary: σ does not
change. But in reality, it does.
Vega hedge is outside the BSM model.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 12 / 20
Example: Delta and vega hedging

Consider an option portfolio that is delta-neutral but with a vega of −8, 000. We
plan to make the portfolio both delta and vega neutral using two instruments:
The underlying stock
A traded option with delta 0.6 and vega 2.0.
How many shares of the underlying stock and the traded option contracts do we
need?

To achieve vega neutral, we need long 8000/2=4,000 contracts of the

traded option.
With the traded option added to the portfolio, the delta of the portfolio
increases from 0 to 0.6 × 4, 000 = 2, 400.
We hence also need to short 2,400 shares of the underlying stock ⇒ each
share of the stock has a delta of one.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 13 / 20
Another example: Delta and vega hedging

Consider an option portfolio with a delta of 2,000 and vega of 60,000. We plan to
make the portfolio both delta and vega neutral using:
The underlying stock
A traded option with delta 0.5 and vega 10.
How many shares of the underlying stock and the traded option contracts do we
need?

As before, it is easier to take care of the vega first and then worry about the
delta using stocks.
To achieve vega neutral, we need short/write 60000/10 = 6000 contracts of
the traded option.
With the traded option position added to the portfolio, the delta of the
portfolio becomes 2000 − 0.5 × 6000 = −1000.
We hence also need to long 1000 shares of the underlying stock.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 14 / 20
A more formal setup
Let (∆p , ∆1 , ∆2 ) denote the delta of the existing portfolio and the two hedging
instruments. Let(νp , ν1 , ν2 ) denote their vega. Let (n1 , n2 ) denote the shares of
the two instruments needed to achieve the target delta and vega exposure
(∆T , νT ). We have
∆T = ∆p + n1 ∆1 + n2 ∆2
νT = νp + n1 ν1 + n2 ν2
We can solve the two unknowns (n1 , n2 ) from the two equations.
Example 1: The stock has delta of 1 and zero vega.
0 = 0 + n1 0.6 + n2
0 = −8000 + n1 2 + 0
n1 = 4000, n2 = −0.6 × 4000 = −2400.
Example 2: The stock has delta of 1 and zero vega.
0 = 2000 + n1 0.5 + n2
0 = 60000 + n1 10 + 0
n1 = −6000, n2 = 1000.
When do you want to have non-zero target exposures?
Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 15 / 20
BSM gamma

Gamma (Γ) is the rate of change of delta (∆) with respect to the price of
the underlying asset.
The BSM gamma is the same for calls and puts:

∂ 2 ct ∂∆t e −q(T −t) n(d1 )

Γ≡ = = √
∂St2 ∂St St σ T − t

0.02
(St = 100, T − t = 1, σ = 20%) 0.02

0.018 0.018

0.016 0.016

0.014 0.014

0.012 0.012

Vega
Vega

0.01 0.01

0.008 0.008

0.006 0.006

0.004 0.004

0.002 0.002

0 0
60 80 100 120 140 160 180 −3 −2 −1 0 1 2 3
Strike d2

Gamma is high for near-the-money options.

High gamma implies high variation in delta, and hence more frequent rebalancing
to maintain low delta exposure.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 16 / 20
Gamma hedging

High gamma implies high variation in delta, and hence more frequent
rebalancing to maintain low delta exposure.
Delta hedging is based on small moves during a very short time period.
assuming that the relation between option and the stock is linear
locally.
When gamma is high,
The relation is more curved (convex) than linear,
The P&L (hedging error) is more likely to be large in the presence of
large moves.
The gamma of a stock is zero.
We can use traded options to adjust the gamma of a portfolio, similar to
what we have done to vega.
But if we are really concerned about large moves, we may want to try
something else.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 17 / 20
Vanna and volga risk

The BMS model has only one risk source: Delta

Delte hedge removes all risk.
When return volatility can also vary stochastically over time, we need to
consider both how much it varies and how it co-moves with the security
price movement
Vanna captures the exposure to the covariation, while volga captures
the exposure of the variation of the volatility
They are the focus of a new generation of option pricing and risk
management models
At one option maturity, the theta variation can be explained (nearly
fully) by volga and vanna variations.
The value of straddle, strangle, and risk reversal can be mapped to
vega, volga, and vanna exposures.
Reference: Option profit and loss attribution and pricing: A new framework

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 18 / 20
Dynamic hedging with greeks

The idea of delta and vega hedging is I call these types of hedging based
based on a locally linear approximation on partial derivatives as dynamic
(partial derivative) of the relation hedging, which often asks for
between the derivative portfolio value frequent rebalancing.
and the underlying stock price and
volatility. Dynamic hedging works well if

80
The overall relation is close to
70 linear. Hence, the hedging
60

50 ratio is stable (does not

40
change much) over time.
Call

30

20 The underlying variable (stock

10

0
price, volatility) varies
−10

−20
smoothly and only changes a
60 80 100 120 140 160 180
ST little within a certain time
Since the relation is not linear, the interval.
hedging ratios change as the
environment change.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 19 / 20
Dynamic versus static hedging

Dynamic hedging can generate large hedging errors when the underlying
variable (stock price) can jump randomly.
A large move size per se is not an issue, as long as we know how much
it moves — a binomial tree can be very large moves, but delta hedge
works perfectly.
As long as we know the magnitude, hedging is relatively easy.
The key problem comes from large moves of random size.
An alternative is to devise static hedging strategies: The position of the
hedging instruments does not vary over time.
Conceptually not as easy. Different derivative products ask for different
static strategies.
It involves more option positions. Cost per transaction is high.
Monitoring cost is low. Fewer transactions.

Liuren Wu ( )
c P& Attribution and Risk Management Options Markets 20 / 20