The Greek Letters: Options, Futures, and Other Derivatives, 8th Edition, 1

Chapter 18
The Greek Letters
Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 1
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, m = 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?

Naked & Covered Positions
Naked position
Take no action
Covered position
Buy 100,000 shares today
What are the risks associated with these
strategies?

Stop-Loss Strategy
This involves:
Buying 100,000 shares as soon as price reaches
$50
Selling 100,000 shares as soon as price falls
below $50

Stop-Loss Strategy continued
Ignoring discounting, the cost of writing and hedging the option

appears to be max(S0−K, 0). What are we overlooking?

Delta (See Figure 18.2, page 381)
Delta (D) is the rate of change of the
option price with respect to the underlying
Call option
price
Slope = D = 0.6
B
A Stock price
Hedge
Trader would be hedged with the position:
short 1000 options
buy 600 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
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 put on the stock
is
N (d 1) – 1

The Costs in Delta Hedging
continued
Delta hedging a written option involves a
“buy high, sell low” trading rule

First Scenario for the Example:
Table 18.2 page 384
Week Stock Delta Shares Cost Cumulative Interest
price purchased (‘$000) Cost ($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 5263.3

Second Scenario for the Example
Table 18.3, page 385
Week Stock Delta Shares Cost Cumulative Interest

price purchased (‘$000) Cost ($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

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

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

Gamma
Gamma (G) is the rate of change of delta
(D) with respect to the price of the
underlying asset
Gamma is greatest for options that are
close to the money

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

Gamma Addresses Delta Hedging Errors
Caused By Curvature (Figure 18.7, page 389)
Call
price
C''
C'
C
Stock price
S S'
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull
2012 16
Interpretation of Gamma
For a delta neutral portfolio, DP  Q Dt + ½GDS 2
DP DP
DS
DS
Positive Gamma Negative Gamma

Relationship Between Delta,
Gamma, and Theta (page 393)
For a portfolio of derivatives on a stock
paying a continuous dividend yield at
rate q it follows from the Black-Scholes-
Merton differential equation that
1 2 2
Q  rSD  s S G = rP
2
Vega
Vega (n) is the rate of change of the value of
a derivatives portfolio with respect to volatility

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

Taylor Series Expansion (Appendix to
Chapter 18)
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
= Delta  DS  Vega  Ds  Theta  Dt  Gamma  DS   

1 2

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

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, short 6000 of the asset
What position in option 1 and the underlying asset will

make the portfolio delta and vega neutral? Answer: Long
4000 options, short 2400 of the asset

Example continued
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, option 2, and the asset 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

Rho
Rho is the rate of change of the value
of a derivative with respect to the
interest rate

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

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

Greek Letters for European Options on
an Asset that Provides a Yield at Rate q
Greek Letter Call Option Put Option

Delta e  qT N (d1 ) e  qT N (d1 )  1
Gamma N (d1 )e  qT N (d1 )e  qT

S 0s T S 0s T
Theta 
 S 0 N (d1 )se  qT 2 T  
 S 0 N (d1 )se  qT 2 T 
 qS 0 N (d1 )e  qT  rKe  rT N (d 2 )  qS 0 N (d1 )e  qT  rKe  rT N (d 2 )
Vega S0 T N (d1 )e qT S0 T N (d1 )e qT
Rho KTe rT N (d 2 )  KTe rT N (d 2 )

Futures Contract 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

Hedging vs Creation of an Option
Synthetically
When we are hedging we take
positions that offset delta, gamma,
vega, etc
When we create an option
synthetically we take positions that
matchdelta, gamma, vega, etc

Portfolio Insurance
In October of 1987 many portfolio
managers attempted to create a put option
on a portfolio synthetically
This involves initially selling enough of the
portfolio (or of index futures) to match the
D of the put option

Portfolio Insurance
continued
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

Portfolio Insurance
continued
The strategy did not work well on October
19, 1987...


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Chapter 18

The Greek Letters

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Ignoring discounting, the cost of writing and hedging the option

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

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

19 55.87 1.000 1,000 55.9 5,258.2 5.1

Options, Futures, and Other Derivatives, 8th Edition,

Week Stock Delta Shares Cost Cumulative Interest

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

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

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Positive Gamma Negative Gamma

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

The value of a portfolio of derivatives

= Delta  DS  Vega  Ds  Theta  Dt  Gamma  DS   

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

What position in option 1 and the underlying asset will

What position in option 1 and the underlying asset will

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Greek Letter Call Option Put Option

Gamma N (d1 )e  qT N (d1 )e  qT

Vega S0 T N (d1 )e qT S0 T N (d1 )e qT

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

Options, Futures, and Other Derivatives, 8th Edition,

The delta of a futures contract on an asset

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

As the value of the portfolio increases, the D

Options, Futures, and Other Derivatives, 8th Edition,

Options, Futures, and Other Derivatives, 8th Edition,

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