Chapter 19

The Greek
Letters

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Example
A bank has sold for $300,000 a European call option
on 100,000 shares of a non-dividend paying stock.
S0 = 49, K = 50, r = 5%, s = 20%, T = 20 weeks,
µ = 13%.
What is the Black-Scholes-Merton value of the
option?

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Example
T = 20/52
d1 = [ln(49/50) + (0.05+0.5 x 0.22) x T]/ (0.2 x T1/2)
= 0.0542
d2 = d1 – 0.2 x T1/2 = -0.0699
N(d1) = 0.5216
N(d2) = 0.4722
PV(K) = $ 49.0477
c = 49 x 0.5216 – 49.0477 x 0.4722 = $2.40 per stock
The contract is worth $240,000.
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Example
A bank has sold for $300,000 a European call option
on 100,000 shares of a non-dividend paying stock.
S0 = 49, K = 50, r = 5%, s = 20%, T = 20 weeks,
µ = 13%.
The Black-Scholes-Merton value of the option is
$240,000
How does the bank hedge its risk to lock in
a $60,000 profit?

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Naked & Covered Positions
Naked position
Take no action

Covered position
Buy 100,000 shares today

What are the risks associated with these

strategies?

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Delta
Delta (D) is the rate of change of the option
price with respect to the underlying
Call option price

Slope D = 0.522
B

A Stock price
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Hedge
Trader would be hedged with the position:
short 1000 options
buy 520 shares.
Gain/loss on the option position is offset by
loss/gain on stock position.
Delta changes as stock price changes and
time passes.
Hedge position must therefore be rebalanced.
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Delta Hedging
This involves maintaining a delta neutral
portfolio.
The delta of a European call on a non-
dividend paying stock is N (d1).
The delta of a European put on the stock is
N(d1) – 1.
Delta hedging a written option involves a
“buy high, sell low” trading rule.

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First Scenario for the Example
Week Stock Delta Shares Cost Cumulative Int. Cost
price purchased ($000) Cost ($000) ($000)

0 49.00 0.522 52,200 2,557.8 2,557.8 2.5

1 48.12 0.458 (6,400) (308.0) 2,252.3 2.2
2 47.37 0.400 (5,800) (274.7) 1,979.8 1.9
....... ....... ....... ....... ....... ....... .......

19 55.87 1.000 1,000 55.9 5,258.2 5.1

20 57.25 1.000 0 0 5,263.3

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At Maturity (Week 20)
Week Stock Delta Shares Cost Cumulative Int. Cost
price purchased ($000) Cost ($000) ($000)

0 49.00 0.522 52,200 2,557.8 2,557.8 2.5

20 57.25 1.000 0 0 5,263.3

Change in option portfolio: 240,000 – (57.25-50) x 100,000 = -$485,000

Change in stock portfolio : 57.25 x 100,000 – 2,557,800 = $3,167,200
Change in cash holdings: (-5,263,300)-(- 2,557,800) = - $2,705,500

Total change: -$23,000

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Second Scenario for the Example
Week Stock Delta Shares Cost Cumulative Int. Cost
price purchased ($000) Cost ($000) ($000)

0 49.00 0.522 52,200 2,557.8 2,557.8 2.5

1 49.75 0.568 4,600 228.9 2,789.2 2.7
2 52.00 0.705 13,700 712.4 3,504.3 3.4
....... ....... ....... ....... ....... ....... .......

19 46.63 0.007 (17,600) (820.7) 290.0 0.3

20 48.12 0.000 (700) (33.7) 256.6

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Theta
— Theta (Q) of a derivative (or portfolio of
derivatives) is the rate of change of the
value with respect to the passage of time.
— The theta of a call or put is usually
negative. This means that, if time passes
with the price of the underlying asset and
its volatility remaining the same, the value
of a long call or put option declines.

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Theta for Call Option
K = 50, s = 25%, r = 5%, T = 1

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Gamma
Gamma (G) is the rate of change of delta
(D) with respect to the price of the
underlying asset.

Gamma is largest for options that are

close to the money.

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Gamma for Call or Put Option
K = 50, s = 25%, r = 5%, T = 1

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G Addresses Delta Hedging Errors
Call price

C''
C'

C
Stock price
S S+DS
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Interpretation of Gamma
For a delta-neutral portfolio, DP » Q Dt + ½G(DS)2

DP DP

DS
DS

Positive Gamma Negative Gamma

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Relationship Between D, G, and Q
Consider a stock paying a continuous
dividend yield at rate q.

A portfolio of derivatives on the stock follows

the Black-Scholes-Merton differential equation:
1 2 2
Q + rSD + s S G = rP
2

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Vega
Vega (n) is the rate of change of the value of a
derivatives portfolio with respect to the volatility
of the underlying asset, s.

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Vega for Call (or Put) Option
K = 50, s = 25%, r = 5%, T = 1

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Taylor Series Expansion
The value of a portfolio of derivatives
dependent on an asset is a function of of the
asset price S, its volatility s, and time t

¶P ¶P ¶P 1 ¶ 2P
DP = DS + Ds + Dt + (DS )2
+
¶S ¶s ¶t 2 ¶S 2

1
= Delta ´ DS + Vega ´ Ds + Theta ´ Dt + Gamma ´ (DS ) + 
2

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Managing Delta, Gamma & Vega
Delta can be changed by taking a position in
the underlying asset.

To adjust gamma and vega it is necessary to

take a position in an option or other derivative.

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Example
Delta Gamma Vega
Portfolio 0 −5000 −8000
Option #1 0.6 0.5 2.0
Option #2 0.5 0.8 1.2

What position in option 1 and the underlying asset will make the
portfolio delta and gamma neutral?
• Answer: Long 10,000 options #1, short 6000 units of the asset

What position in option 1 and the underlying asset will make the
portfolio delta and vega neutral?
• Answer: Long 4000 options #1, short 2400 units of the asset

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Example (cont.)
Delta Gamma Vega
Portfolio 0 −5000 −8000
Option 1 0.6 0.5 2.0
Option 2 0.5 0.8 1.2

What position in the asset and options 1&2 will make the portfolio delta,
gamma, and vega neutral?
• We solve −5000+0.5w1 +0.8w2 =0
−8000+2.0w1 +1.2w2 =0
to get w1 = 400 and w2 = 6000. We require long positions of 400 and 6000
in option 1 and option 2.
• A short position of 3240 in the asset is then required to make the
portfolio delta neutral
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Rho
Rho is the rate of change of the value of a
derivative with respect to the interest rate.

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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.
There are economies of scale
As portfolio becomes larger hedging becomes less
expensive per option in the portfolio

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Scenario Analysis
A scenario analysis involves testing the effect
on the value of a portfolio of different
assumptions concerning asset prices and their
volatilities

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Greek Letters for European Options
Asset that provides a yield at rate q.

Greek Letter Call Option Put Option

Delta e - qT N (d1 ) e - qT [N (d1 ) - 1]

N ¢(d1 )e - qT N ¢(d1 )e - qT
Gamma
S 0s T S 0s T

Theta - S 0 N ¢(d1 )se - qT 2 T ( ) - S 0 N ¢(d1 )se - qT 2 T ( )

- qT - rT - qT
+ qS 0 N (d1 )e - rKe N (d 2 ) + qS 0 N (-d1 )e + rKe - rT N (-d 2 )

Vega S 0 T N ¢(d1 )e - qT S 0 T N ¢(d1 )e - qT

Rho KTe - rT N (d 2 ) - KTe - rT N (-d 2 )

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Futures Can Be Used for Hedging
The delta of a futures contract on an asset
paying a yield at rate q is e(r−q)T times the
delta of a spot contract.

The position required in futures for delta

hedging is therefore e−(r−q)T times the position
required in the corresponding spot contract.

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Hedging vs Synthetic Option
When we are hedging we take positions that
offset delta, gamma, vega, etc.

When we create an option synthetically,

we take positions that match delta, gamma,
vega, etc

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Portfolio Insurance
In October 1987, many portfolio managers
attempted to create put options synthetically.

This involves initially selling enough of the

portfolio (or of index futures) to match the D of
the put option

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Portfolio Insurance
As the value of the portfolio increases, the D
of the put becomes less negative and some
of the original portfolio is repurchased.
As the value of the portfolio decreases, the D
of the put becomes more negative and more
of the portfolio must be sold.
The strategy did not work well on October 19,
1987...
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