Risk Management and

The Greek Letters

Presented By:
Dr. Komal Bhardwaj

1
What is corporate risk management, and
why is it important to all firms?

• Corporate risk management relates to the

management of unpredictable events that
would have adverse consequences for the firm.
• All firms face risks, but the lower those risks
can be made, the more valuable the firm,
other things held constant. Of course, risk
reduction has a cost.
 Definitions of different types of
risk
• Speculative risks – offer the chance of a gain as
well as a loss.
• Pure risks – offer only the prospect of a loss.
• Demand risks – risks associated with the demand
for a firm’s products or services.
• Input risks – risks associated with a firm’s input
costs.
• Financial risks – result from financial transactions.
 Definitions of different types of
risk
• Property risks – risks associated with loss of a
firm’s productive assets.
• Personnel risk – result from human actions.
• Environmental risk – risk associated with
polluting the environment.
• Liability risks – connected with product,
service, or employee liability.
• Insurable risks – risks that typically can be
covered by insurance.
What are the three steps of corporate risk
management?

1. Identify the risks faced by the firm.

2. Measure the potential impact of the
identified risks.
3. Decide how each relevant risk should
be handled.
 What can companies do to minimize
or reduce risk exposure?
• Transfer risk to an insurance company by paying
periodic premiums.
• Transfer functions that produce risk to third parties.
• Purchase derivative contracts to reduce input and
financial risks.
• Take actions to reduce the probability of occurrence
of adverse events and the magnitude associated
with such adverse events.
• Avoid the activities that give rise to risk.
What is financial risk exposure?

• Financial risk exposure refers to the risk

inherent in the financial markets due to
price fluctuations.
• Example: A firm holds a portfolio of
bonds, interest rates rise, and the value
of the bond portfolio falls.
Financial Risk Management Concepts

• Derivative – a security whose value is derived

from the values of other assets. Swaps, options,
and futures are used to manage financial risk
exposures.
• Futures – contracts that call for the purchase or
sale of a financial (or real) asset at some future
date, but at a price determined today. Futures
(and other derivatives) can be used either as
highly leveraged speculations or to hedge and
thus reduce risk.
Financial Risk Management Concepts

• Hedging – usually used when a price change could

negatively affect a firm’s profits.
– Long hedge – involves the purchase of a futures
contract to guard against a price increase.
– Short hedge – involves the sale of a futures contract to
protect against a price decline.
• Swaps – the exchange of cash payment
obligations between two parties, usually because
each party prefers the terms of the other’s debt
contract. Swaps can reduce each party’s financial
risk.
How can commodity futures markets be
used to reduce input price risk?

• The purchase of a commodity futures

contract will allow a firm to make a
future purchase of the input at today’s
price, even if the market price on the
item has risen substantially in the
interim.
 Introduction
• An option's price can be influenced by a number of
factors that can either help or hurt traders depending
on the positions they take. Successful traders
understand the factors that influence options pricing,
which include the so-called Greeks.
• They are a set of risk measures named after the
Greek letters that denote them, which indicate how
sensitive an option is to time-value decay, changes in
implied volatility, and movements in the price of its
underlying security.

11
 Goals
• OTC risk management by option market
makers may be problematic due to unique
features of the options that are not available
on exchanges.
• Many dimensions of risk (greeks) must be
managed so that all risks are acceptable.
• Synthetic options and portfolio insurance

12
 Delta
• Delta (D) is the rate of change of the option price with
respect to the underlying:
=f/S
• Remember, this creates a hedge (replication of option
payoff):
*S - f = 0
• Two ways to think about it:
– If S =$1 => f = $
– If short 1 option, then need to buy  shares to
hedge it

13
 Example
• Let c=0.7. What does this mean?
• -c + 0.7S = 0
• Short call can be hedged by buying 0.7
shares or
• For $1 change in S, C changes by 70
cents.

14
 Delta AKA: Hedge Ratio
Delta (D) is the rate of change of the option price with respect to the
underlying. (I.e., How does the option price change as the underlying
price changes?)

Option
price

Slope = D
B
A Stock price
©David Dubofsky and 19-
15
Thomas W. Miller, Jr.
 More on Delta Hedging
Delta is the (fractional) number of shares required to hedge one call.
• Positions in the fractional shares and call have opposite signs.
• For calls, delta lies between 0 and 1.
• For puts, delta lies between –1 and 0.
• Strictly speaking, the riskless hedge exists only for small changes in the stock
price and over very small time intervals.
• As time passes and/or the stock price changes, the D of the call changes (as
measured by gamma).
• As D changes, shares of stock must be bought or sold to maintain the riskless
hedge.
 Delta
• Volatility moves delta: An increase in volatility will make the delta of all
options move towards 0.50. An In-The-Money (ITM) option would fall
towards 0.50, while an Out-Of-The-Money (OTM) option will rise towards
0.50 as volatility increases. On the other hand, a decrease in volatility will
make the delta move away from 0.50. The in-the-money options get closer
to 1 and the out-of-the-money option closer to zero as volatility decreases.

17
 Delta
• Moneyness affects delta: As the price of the underlying
moves up or down, the options move in and out of money,
leading to a change in delta. An At-The-Money (ATM) option
has a delta of 0.50. An in-the-money option has delta >0.50,
while an out-of-the-money option has a delta <0.50.
• The change in delta is measured by gamma. Gamma
measures the rate of change of an options delta to a change
in the underlying’s price. Gamma is highest for at-the-money
options in the short term. While in-the-money and out-of-the-
money options have low gamma.

18
 Delta
• Expiration: With more time for an option till expiration, the
greater is the uncertainty that it will remain an in-the-money
or an out-of-the-money. A delta of 0.50 means the greatest
uncertainty. Thus, they tend to move towards 0.50. But as the
options approach expiry, delta of in-the-money and out-of-
the-money options move away from 0.50, and the uncertainty
abates.
• It is important to know the relative positions of the other
greeks. If a position has a directional bias, one has to monitor
other variables like theta, volatility, etc., to know if the trade is
on course. If not, one has to take corrective positions or exit.
This is true even for non-directional positions.
19
 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

c
 0
t
20
 Theta
• Volatility: An increase in volatility will cause an increase in theta for all
options, while a decrease in volatility will cause a decrease in theta for
all options. This is because an increase in volatility results in an increase
in option prices.
• Expiration: As the time for expiration approaches, theta for at-the-
money options increases while remaining unchanged for in-the-money
and out-of-the-money. Ideally, strategies that are theta-centric can be
built around at-the-money options to take advantage of higher theta.
For example, income strategies like iron fly and credit spreads can be
built when the time for expiration is very short.
• Moneyness: Theta changes as the option moves in and out of the
money. Theta decays more as we get closer to the money and decays
slower as it gets away from it. At-the-money options have the highest
theta decay, while in-the-money and out-of-the-money have lower
decay due to theta.

21
 Gamma
• Gamma (G) is the rate of change of delta
(D) with respect to the price of the
underlying asset
• In our previous example:
  u   d 0.95455  0
    0.23864
S Su  Sd 22  18
• Assets linear in S (futures, stock) do not
affect Gamma.

22
 Gamma
• Time: Short-term options have lower vega value than their long-term
counterparts. A vega of a weekly option with the same strike price
will have a lower value than a vega of a monthly option of the same
strike price. As the time to expiration nears, vega reduces. Implied
volatility is more in the short-term options and less in the long-term
options. So, despite a smaller vega value in the short-term options,
vega is affected as implied volatility changes much more in the short
term.
• Volatility: An increase in volatility leads to an increase in vega and a
decrease in volatility leads to a decrease in vega.
• Moneyness: At-the-money options have the maximum vega, while
in-the-money and out-of-the-money options have low vega.

23
 Interpretation of Gamma
• For a delta neutral portfolio,
dP » Q dt + ½GdS 2

dP dP

dS
dS

Positive Gamma Negative Gamma

24
 Delta-Gamma Hedge

• To remove delta effects via a delta-neutral hedging strategy using options, the
trader employed one option.
• To remove another effect, i.e., gamma, the trader will need to use a second
option. Suppose S = K1 = $100, r = 8%, s = 30%, T = 180 days, and K2=110.
Then, by using the BSOPM, one can generate the following information.

Call Option Call Option

Variable (K=100) (K=110) Stock
Price $10.30 $6.06 $100
Delta 0.6151 0.4365 1
Gamma 0.0181 0.0187 0

©David Dubofsky and 19-

25
Thomas W. Miller, Jr.
• Suppose the trader decides to sell 200 call options with the strike of 100, each
on 100 shares of stock.
• Because the trader wants to create a delta-gamma hedged portfolio, the
trader must simultaneously solve for the number of shares to purchase, S,
and the number of K=110 calls to purchase, K110.
• This is straightforward because the gamma of the stock is zero, and the
portfolio gamma is a weighted sum of the constituent gammas. The trader
wants a gamma of zero. That is,

0 = (-200*100*0.0181) + (S*0) + (K110*100*0.0187)

• which yields K110 = 193.583 for any value of S.

©David Dubofsky and 19-

26
Thomas W. Miller, Jr.
• Assuming the trader buys 194 of the calls having a strike price of 110.
• Solving for the number of shares is accomplished by noting that the delta of a
share equals one and that the trader also wants to hold a delta neutral
portfolio. Accordingly,

0 = (-200*100*0.6151) + (S*1) + (194*100*0.4365)

• Therefore S = 3,834 makes the portfolio delta-gamma neutral, given the other
positions.
• To examine the performance of this delta-gamma hedge, suppose the stock
price were to change to either $101 or to $99.

©David Dubofsky and 19-

27
Thomas W. Miller, Jr.
 Stock K=100 Call K=110 Call Portfolio Pct.
Chg. Price Price Price Value (S0 =
100)
99 9.6984 5.6310 $294,839
0.0007 100 10.3044 6.0580 $294,837
101 10.9285 6.5040 $294,841
0.0015

(Note how the value of the portfolio remains nearly unchanged, even when the stock
price changes up or down by 1%.)

At the same time, note that the portfolio delta of zero remains (virtually) unchanged:

Original D, @ S = 100 = (3834)(1) + (194)(100)(0.4365)

+ (-200)(100)(0.6151) = 0.10

@ S = 99, D = (3834)(1) + (194)(100)(0.4178)

+ (-200)(100)(0.5967) = 5.32

@ S = 101, D = (3834)(1) + (194)(100)(0.4552)

+ (-200)(100)(0.6330) = 4.88
©David Dubofsky and 19-
28
Thomas W. Miller, Jr.
 Practical applications
• Delta: Investors seeking to hedge existing positions (reduce
risk) often prefer options with deltas closer to 1 (calls) or -1
(puts), as their price movements closely mirror the underlying
asset.
• Gamma: Traders utilising directional strategies (betting on
price movements) might favour options with higher gamma
for amplified potential returns, but be aware of the increased
volatility.
• Theta: Options with longer expirations offer more time for the
underlying asset's price to move in your favour, mitigating
theta decay's impact. However, remember the time value
component of the premium.

29
THANK YOU

30