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Financial risk management using derivatives

Author : Ionescu Andreea Laura


Coordinator Prof Dr. Univ :Ion Stancu



Abstract
Based on the concept of financial risk management through hedging strategies, in this
paper we propose to analyze the performance of dynamic hedging strategies with daily and
weekly rebalancing of put and call options contracts having as underlying asset - Erste Bank
Group from 1 January 2011 -30 December 2012.
For evaluation we used the methodology options contracts Black - Scholes and for the
volatility estimation we used the implied volatility method.
Empirical and practical results, largely confirmed theoretical assumptions drawn from
the literature reviewed.

Keywords: risk management, hedging strategies, derivatives

Introduction
Widespread corporate use of derivatives securities is well documented. By the prevalence
of derivatives use and impact of ex bad transactions has led investors, creditors and regulators
to became increasingly concerned about how firms use these derivatives instruments, little
empirical evidence documents the effect of derivatives on firms risk.
Types of derivative instruments chosen also depend on firms exposure risk in ways that
are a priori consistent with hedging behavior.
Taking into consideration all the above, the evidence is consistent with firms using
derivatives for hedging purposes and not to decrease shareholders risk .


Literature review

Financial risk management using derivatives is the subject to numerous case studies on
international level that focus on microeconomic sphere. The calculation and estimation vary
from author to author, and distribution channels impact financial results
Presented below are a couple of case studies regarding the results if using derivatives to
hedge or not on firms risk.
In 1999, Wayne R. Guay examines in his paper derivatives' roles in firms initiating
derivatives use. The results are consistent with firms using derivatives to hedge, and not to
increase, entity risk. Firm risk, measured using several methods declines following derivatives
use. Realized risk reductions and decisions to initiate derivatives programs vary across firms
with the expected benefits from hedging. The findings emphasize the importance of hedge-
accounting rules that incorporate the impact of derivatives and hedged items simultaneously.
In 2007, using a sample of 6,888 non-financial firms, Gregory W Brown examined the
effect of derivative use on firms risk measures and value. A first control for endogeneity was
performed by matching users and non-users on the basis of their propensity to hedge. The second
one was in order to estimate the effect of omitted variable bias on our inferences . The results are
that the use of financial derivatives reduces both total risk and systematic risk. The effect of
derivative use on firm value is positive but weak, and is more sensitive to endogeneity and
omitted variable concerns.
This increased sensitivity could account for the mixed evidence in the literature on the
effect of hedging on firm value.
In 2009, D.Vallire,E. Denis, Y. Kabanov considered a continuous-time model of a
financial market with proportional transaction costs. The result is a dual description of the set of
initial endowments of self-financing portfolios super-replicating an American-type contingent
claim. The latter is a right-continuous adapted vector process describing the number of assets to
be delivered at the exercise date. Additional, a specific class of price systems, called coherent,
and show that the hedging endowments are those whose values are larger than the expected
weighted values of the payoff process for every coherent price system used for the
evaluation of the assets.
In 2010, Flavio Angelini and Stefano Herzel explicitly compute closed formulas for the
minimal variance hedging strategy in discrete time of a European option and for the variance of
the corresponding hedging error under the hypothesis that the underlying asset is a martingale
following a geometric Brownian motion. The formulas are easy to implement, hence the optimal
hedge ratio can be employed as a valid substitute of the standard BlackScholes delta, and the
knowledge of the variance of the total error can be a useful tool for measuring and managing the
hedging risk.
The most recent research belongs to Jitka Hilliard and Wei Li, published in 2013 and
developed a new volatility measure: the volatility implied by price changes in option contracts
and their underlying, referred to this as price-change implied volatility. In this study, the authors
compared moneyness and maturity effects of price-change and implied volatilities, and their
performance in delta hedging. They found that delta hedges based on a price-change implied
volatility surface outperform hedges based on the traditional implied volatility surface when
applied to S&P 500 future options.

Database
The data used in the analysis are given in number of intra-day 34 457 spanning a period
of 2 years and 1 January 2011 - 30 December 2012. Day exchange is between 10.00-16.30pm,
making a simple average we have about 70 transactions per day or transaction 5 minutes.

Options are analyzed in 15 separate categories, namely:

5 categories of moneyness, moneyness which represents the ratio between the spot price (S) of
the underlying asset and the strike price (K) thereof, we have the following types:
o DOTM deep out of the money moneyness < 0.94
o OTM out of the money moneyness (0.94 0.97)
o ATM at the money - moneyness (0.97 1.03)
o ITM Into the money moneyness (1.03 1.06)
o DITM deep Into the money moneyness>1.06
3 categories representing time until due date (t - days):
o On short term t < 60
o On medium term 60 < t <180
o On long term t > 180


Research Methodology

In this section I will present the main methods used in order to determinate the input
needed to be used on determine the most efficiency hedging strategy.
Thus, in order to evaluate the anticipated price of the options we used Black- Scholes
Methodology.
Assumptions of the model are:
The asset pays no dividends during the option time period
The option used is European type
Markets are efficient
There are no commissions
The interest rate remains constant
Data used follow a lognormal distribution

The Black Scholes valuation of a call (C) and put (P) is as follows:




d1 =
ln

+(+

2
2
)()


d2 = d1 -

To use the Black Scholes evaluation we need five parameters of which 3 are found in the
market: the spot price, the exercise price and time to maturity. The other two, the annual interest
rate volatility respectively, must be estimated. Interest rate is commonly used yield to maturity of
bonds issued by state (zero-coupon bonds), for the same duration (maturity) as the derivative
asset.
Step1 .In oder to obtain the 5
th
parameter, that is volatility, we used the implied volatility
method. It has been shown that the use of implied volatility substantially reduce the number of
required data and has improved performance models. In our analysis we use implied volatility
resulting from the Black Scholes formula by inverting and equalizing with options market price.



C = SN(d
1
) K e
-r(T-t)
N(d
2
)
P = K e
-r(T-t)
N(-d
2
) - SN(-d
1
)

Where,
S Underlying Asset Price
K Strike Price
r Free risk interest rate
Anual volatility
T-t no of days until due date
N Cumulated probability

Thus we obtained the following results:
Tabel 2
Volatilitatea implicit calculat cu modelul Black-Scholes
Optiuni Call Optiuni Put
Moneyness Zile pana la scadenta Zile pana la scadenta
S/K <60 60-180 >180 <60 60-180 >180
<0.94 26,52% 22,22% 20,94% 36,20% 31,83% 29,53%
0.94 - 0.97 24,82% 21,05% 18,48% 28,78% 26,01% 27,42%
0.97 - 1.03 24,05% 21,18% 18,28% 30,34% 26,97% 28,23%
1.03 - 1.06 25,29% 20,98% 16,60% 34,84% 29,52% 31,04%
>1.06 39,03% 20,84% 13,54% 34,61% 34,05% 36,24%
Volatilitatea implicit este obinut prin inversarea formulei de evaluare Black Scholes i egalarea ei cu preul pieei.
Datele reprezint medii ale volatilitailor n funcie de moneyness i de timpul pn la maturitate.


Step2. The following step was to calculate and present a procedure for minimizing errors
Black Scholes model and then we apply this procedure successively separate on implied
volatility for CALL and PUT options. Having the volatility has chosen a single value that
minimizes errors in the evaluation of the Black - Scholes. Errors are defined as the difference
between the option price calculated theoretically from the model, and the market price of the
option.
The procedure to minimize Black Scholes errors :



Applying this procedure on all data to get a fairly accurate assessment of the performance
evaluation of the chosen model. Per total, the two years of analysis have 462 trading days.
After applying this procedure on the database described above we obtained the following:












= [ (

=
(

()
)

]

Call Options

min
= 9.61%;
max
= 21.04%
Errors average that result from the analysis is SEcall = 12326.17 for all call option.
The model tends to overestimate OTM options (outside money) and to underestimate the options
ITM (in the money).


Put options

Chart within the paper shows that valuation errors are quite large especially DITM and
ATM options. The best assess OTM options.










mIn
= 15.49%

max
= 26.30%
Errors average:
SE
put
= 13,279.79

Step3. Test the efficiency of the strategies chosen.


Covered CALL Strategy

Covered Call strategy results:













Covered Put Strategy


Covered Put strategy results:




Step 4. The final step of this paper was to evaluate the cost of these 2 types of strategies.
In order to do that we calculated the net results: one without the strategy and other with
strategy for both Covered Call and Covered Put strategies.
The methodology for this cost calculation is more detailed in the paper, thus here will be
presented only the results







Hedging Call Results:



As recommended daily share price over the strike price, the net result is negative and less
without strategy than using the Covered Call strategy in all 15 cases.
Regarding the effectiveness of the strategy notes that it generated profits in all cases
except the ATM option with maturity over 180 days, while confirming the results obtained in our
empirical analysis in section 3.
According tunes, the net results were lower than the premiums received initial value
generally determined strategies as having the smallest errors preserving the best first initial
charging


Hedging Put Results:


Moneyness/
Zile pana la
scadenta
Cu strategie Fara strategie Cu strategie Fara strategie Cu strategie Fara strategie
<0.94 19.24 -401.81 72.40 -636.80 55.61 -366.87
0.94 - 0.97 38.29 -505.54 123.93 -741.23 164.32 -558.01
0.97 - 1.03 29.98 -576.07 190.03 -759.60 -10.30 -623.57
1.03 - 1.06 257.86 -611.38 290.07 -850.86 249.40 -684.03
>1.06 373.78 -635.64 431.76 -887.45 376.19 -713.98
Rezultate hedging CALL
60 123 182
Moneyness/
Zile pana la
scadenta
Cu strategie Fara strategie Cu strategie Fara strategie Cu strategie Fara strategie
<0.94
189.13 202.20 335.91 346.31 287.86 319.46
0.94 - 0.97
137.72 149.89 218.45 237.96 208.46 218.74
0.97 - 1.03
86.15 96.57 152.90 172.14 128.87 148.54
1.03 - 1.06
48.14 58.05 104.88 116.45 57.15 99.18
>1.06
22.37 32.19 75.98 86.07 -9.80 64.10
Rezultate hedging PUT
60 123 182
Recommended daily share price over the strike price, the net result is no greater without
strategy than using Covered Put strategy in all 15 cases.
Regarding the effectiveness of the strategy notes that it generated profits in all cases
except DOTM type option with maturity over 180 days, while confirming the results obtained in
our empirical analysis in section 3.
According tunes, the net results were lower than the premiums received initial value
generally determined strategies as having the smallest error preserving also received best original
first.
The results reflected lower net cost strategy, that is why results without strategy
in the case of non-exercise are better.

Conclusions

In this paper, we test the performance of dynamic hedging strategies with daily and
weekly rebalancing of put and call options contracts having as underlying asset - Erste share for
a period of two years using a number of 34457 intra-day data.
For the evaluation methodology was used options contracts Black - Scholes model
strategies used to test the performance Covered Call and Covered Put.
Necessary to estimate volatility implied volatility method was performed, the results of
calculations are presented along the paper.
Based on the analyzed performed I noticed that Black Scholes model tends to
overestimate and underestimate OTM options ITM options, and this is very evident in the case of
our test call options. Put option valuation errors were significantly higher (almost double), large
deviations recorded most DITM and ATM options, which are heavily undervalued.
Regarding the performance of dynamic hedging strategies Covered Call found that the
most effective strategies are for DOTM and OTM options with a maturity of 180 days, the
biggest errors recorded in general for ATM options .If Covered Put strategy, the most effective
strategies were DOTM and OTM with a maturity less than 60 days. The largest error recorded
for DOTM and OTM options with maturity greater than 180 days.
Practical assessment strategies largely confirmed the empirical results described above.

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