Introduction

The Greeks
List of “Greeks”
Related issues

Derivatives and Risk Management

Lecture 12: The Greeks

Søren Hesel

Department of Business and Management

Fall 2022

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 Introduction
The Greeks
List of “Greeks”
Related issues

Outline

1 Introduction

2 The Greeks

3 List of “Greeks”

4 Related issues

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 Introduction
The Greeks
List of “Greeks”
Related issues

Introduction

Risk management:
• Needs to ensure that changes in financial market values does
not destroy too much wealth
• Banks and other large institutions are heavily regulated and need
to produce risk measures to assess their positions

We will be concerned with the following two questions:

1 How to construct hedge strategies/replicating portfolios
2 How to generate measures of risk from our models

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 Introduction
The Greeks
List of “Greeks”
Related issues

Hedging strategies
Introduction

A financial institution that sells an option to a client in the OTC-market

needs to manage it’s risk.

• Sold a call option

• How do we hedge the position?
△ Take up a specific position or not
△ Use a specific trade strategy to hedge

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 Introduction
The Greeks
List of “Greeks”
Related issues

Hedging strategies cont’d

Taking positions

• Buy the opposite position at the exchange

▶ but maybe the opposite position isn’t traded at the exchange
▶ remember: only standardized options are exchange traded
• Do nothing ⇝ “naked position”
▶ works well if option expires out-of-the-money
▶ potential loss = ∞
▶ but cheap. . .
• Buy the underlying/futures of the underlying
⇝ “covered position”
▶ works well if option expires in-the-money
▶ potential loss = St − ct
▶ but expensive. . .

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 Introduction
The Greeks
List of “Greeks”
Related issues

Hedging strategies, cont’d

• Stop-loss strategy
▶ Buy the stock when the option is in-the-money, sell the stock when
it is out-of-the-money
▶ It seems that the cost, Q, of this strategy equals the intrinsic value
of the call; i.e.,

Q = max(0, S0 − K) < max(0, S0 − Ke−rT ) < c0

⇝ arbitrage?!?
▶ What’s missing?
1 Every time the stock is in-the-money you incur a loss of interest
2 More importantly: purchases and sales cannot be made at exactly the
same price K ⇝ loss due to bid-ask spread and transaction costs
▶ This is not a perfect hedge!
• We need to be a bit more sophisticated...
• Replicating strategies - using “the Greeks”!

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 Introduction
The Greeks
List of “Greeks”
Related issues

Stop loss

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Delta

The Delta of an option (or other derivative) is defined as

∂f
∆=
∂S
i.e. the rate of change of the option price wrt. the price of the
underlying asset. Related to fixed income by DV01:

• Derivatives of price with respect to underlying yield curve

pvdown − pvup
Dv =
2 × 0.001

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Delta cont’d
Size of delta

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Delta of call and put

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Delta of a portfolio
P
Let Πt = Ni=1 xit fit denote the value of a portfolio of options or other
derivatives dependent on a single asset with price S, where xi is the
quantity of option i and fi is the price of option i.

The delta of the portfolio is then given by

∂Π X ∂fit X
N N
∆Π = = xit = xit ∆i
∂S ∂S
i=1 i=1

Delta-neutral portfolio:
A portfolio is called delta-neutral if
X
N
∆Π = xit ∆i = 0
i=1

i.e. the change in Π is locally independent of S.

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Delta of a call option

Recall the Black-Scholes formula for a call option

c = SN(d1 ) − Ke−rT N(d2 )

It can be shown that, the delta of a call option is given by

∂c
∆call = = N(d1 ) > 0
∂S

• A long (short) position in a call option should be hedged with a

short (long) position of N(d1 ) in the underlying asset at any given
time.

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Example: Delta-hedging of a short call

(Tutorial: Replicate Tables 18.2–18.3)

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%, σ = 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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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Example: Delta-hedging of a short call, cont’d

(Tutorial: Replicate Tables 18.2–18.3)

Week Stock Delta Shares Cost Cumulative Interest

price purchased cost
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

At maturity the option ends in the money and the underlying stock is
sold for $50 each:
cumulative cost = $263, 300
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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Delta of a put option

Recall the Black-Scholes formula for a put option

p = c − S + KerT = Ke−rT [1 − N(d2 )] −S [1 − N(d1 )]

| {z } | {z }
=N(−d2 ) =N(−d1 )

From the Black-Scholes formula it follows that the delta of a put

option is given by

∂p
∆put = = −N(−d1 ) < 0
∂S

• A long (short) position in a put option should be hedged with a

long (short) position of N(−d1 ) in the underlying asset at any
given time.

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Delta of a forward

The value of a forward contract is ft = St − Ke−r(T−t) , hence

∂ft
∆forward = =1
∂S

• A short (long) forward is hedged by purchasing (shorting) one

share of the underlying.

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Delta of a futures

Due to the marking-to-market of a futures its value change equals the

change in the futures price.

Assuming that r is constant ⇒ the futures = the forward price; i.e.,

Φt = Ft = St er(T−t) .

The delta is then given by

∂Φt
∆futures = = er(T−t)
∂S
The delta of the futures is different from the delta of the forward - this
is due to the daily marking-to-market.

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Gamma

The Gamma of an option is defined as

∂2 f ∂
Γ= 2
= ∆
∂S ∂S

• A small Γ ⇒ ∆ changes slowly ⇒ adjustments to keep a portfolio

delta-neutral need to be made only relatively infrequently
• A large Γ ⇒ ∆ is highly sensitive to St ⇒ quite risky to leave a
delta-neutral portfolio unchanged for any length of time.
• Related to fixed income with DDV01
pvup + pvdown − 2pv
Ddv =
0.0012

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Gamma cont’d
Depending on stock price

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Gamma cont’d
Depending of time to maturity

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Gamma of a portfolio

The gamma of a portfolio is given by

∂2 X X ∂2 fit X
N
! N N
∂2 Π
ΓΠ = = x f
it it = x it = xit Γi
∂S2 ∂S2 ∂S2
i=1 i=1 i=1

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Gamma of a call and put option

From Black-Scholes formula it follows that the gamma of a call and

put option is given by

1
Γcall = Γput = N ′ (d1 ) √ >0
St σ T − t

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Gamma of other assets

Gamma of underlying asset:

∂
ΓS = ∆S = 0
∂S

Gamma of forward and futures:

Γforward = Γfutures = 0

(⇝ remember the ∆ for forward and futures does not depend on S)

Hence to control the Γ of a portfolio we have to bring more options

into play!

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Theta
The Theta of an option is defined as
∂f
Θ=
∂t
i.e. it is the rate of change of the option price with respect to the
passage of time.

Note Θ is not the same type of hedge parameter as ∆ and Γ :

• no uncertainty about the passage of time
• doesn’t make sense to hedge against the effect of passage of
time

Relationship between Delta, Theta and Gamma:

The price of a derivative or a portfolio of derivatives must satisfy the
Black-Scholes-Merton PDE, i.e. we get the following relationship
1 2 2
σ S ΓΠ + rS∆Π + Θ = rΠ
2
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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Vega

The vega of a portfolio of derivatives is defined as

∂Π
V=
∂σ
i.e. it is the rate of change of the value of the portfolio with respect to
the volatility of the underlying asset.

Using Black-Scholes, the vega of a call option is given by

√
Vcall = St T − tN ′ (d1 )

• but BS assumes constant volatility ⇝ inconsistent!!

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Vega cont’d

• Do we then believe the measure?

• Relatively important since c is very sensitive to σ
▶ this means that constant volatility is a very critical assumption!
• For fixed income, vega is much more complex as a (nonflat)
surface
▶ Tenors in one dimension
▶ Maturities in the other dimension
• Normally approximated similar to delta: (also for fixed income)

pvup − pv
V=
1%

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 Introduction Delta
The Greeks Gamma
List of “Greeks” Theta
Related issues Other Greeks

Rho

The rho of a portfolio of derivatives is defined as

∂Π
ρ=
∂r
i.e. it is the rate of change of the value of the portfolio with respect to
the interest rate.

The rho of a call option is given by

ρcall = K(T − t)e−r(T−t) N(d2 )

• again BS assumes a constant r ⇝ inconsistent!!

• ρcall is reasonably small, in particular for short options

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 Introduction
The Greeks
List of “Greeks”
Related issues

List of “Greeks”

According to the Black-Scholes-Merton model...

Greek Call option Put option

∂f
∆= ∂S N(d1 ) N(d1 ) − 1
∂2 f N ′ (d1 ) N ′ (d1 )
Γ= ∂S2
√
St σ T−t
√
St σ T−t
∂f St N ′ (d1 )σ St N ′ (d1 )σ
Θ= ∂t
√
2 T−t
− rKe−r(T−t) N(d2 ) √
2 T−t
+ rKe−r(T−t) N(−d2 )
√ √
V= ∂f
∂σ St T − t N ′ (d1 ) St T − t N ′ (d1 )
∂f
ρ= ∂r K(T − t)e−r(T−t) N(d2 ) −K(T − t)e−r(T−t) N(−d2 )

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 Introduction
The Greeks Hedging in practice
List of “Greeks” Portfolio insurance
Related issues

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
• As portfolio becomes larger, hedging becomes less expensive ⇝
hedge net positions, not individual positions
• Scenario analysis: testing the effect on the value of a portfolio of
different assumptions concerning asset prices and their
volatilities

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 Introduction
The Greeks Hedging in practice
List of “Greeks” Portfolio insurance
Related issues

Synthetic options vs. hedging

• hedging involves taking positions that offset Delta, Gamma,

Vega,...
• creating an option synthetically involves taking positions that
match/replicate Delta, Gamma, Vega,...

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 Introduction
The Greeks Hedging in practice
List of “Greeks” Portfolio insurance
Related issues

Portfolio insurance

• idea: acquire put options on your portfolio to obtain a lower

bound on the future value of the portfolio
• the required put options are often created synthetically by selling
enough of the portfolio (or of index futures) to match the Delta of
the put option
• as the value of the portfolio increases, the Delta of the put
becomes less negative ⇝ repurchase some of the original
portfolio
• as the value of the portfolio decreases, the Delta of the put
becomes more negative ⇝ sell more of the portfolio
• if many traders do this, the movements of the stock market will
be magnified
• Black Monday, October 19, 1987...

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