Short - DELTA OPTION PDF

Lecture 11:
The Greeks and Risk Management
This lecture studies market risk management from

the perspective of an options trader. First, we show how
to describe the risk characteristics of derivatives. Then,
we construct portfolios that eliminate these risks.
I. Motivation
II. Partial Derivatives of Simple Securities
III. Partial Derivatives of European Options
IV. The Gamma-Theta Relationship
V. Popular Options Strategies and the Greeks
VI. Risk Management
A. Portfolio Hedging
B. Delta Hedging
C. Gamma Hedging
D. Simultaneous Delta and Gamma Hedging
E. Theta, Vega, and Rho Hedging
VII. The Cost of Greeks
VIII. Other Risk Management Approaches
Risk Management with Options
I. Motivation
Traders who write derivatives must hedge their risk

exposure.
Wed like to simply characterize the main risks
associated with a complicated portfolio of positions
on an underlying.
Ultimately, thats where were headed.
Example: Suppose youre trading options for

Goldman-Sachs, and you just wrote, for $5, a 10-
week, ATM European call.
The underlyings trading at $50, and D 50%.

The risk-free rate is 3.0%.
Black-Scholes tells you that the call option is worth

$4.50. How can you make the profit of $0.50 per
option without risk?
Buy the same option for $4.50 elsewhere.

Spend $4.50 on a replicating portfolio (i.e., buy a
synthetic option) that has the same payoff.
Bus 35100 Page 2 Robert Novy-Marx

Question 1 : can you really perfectly replicate the

options payoff?
That is, can you perfectly hedge away all of the risk
associated with the call you wrote?
You can if both:

The binomial tree model perfectly describes the
stock price dynamics.
You can trade without transaction costs.
You can if both:

The log-normal model perfectly describes the
stock price dynamics.
You can trade continuously and without transaction
costs.
But in the real world:
We cant trade continuously.

Transaction costs can be substantial.
The volatility of the underlying and the risk-free
rate arent constant.

Question 2: So what should you do, if you cant

perfectly hedge the risk of the call youve written?
1. Identify the different sources of risk.
The value of the call changes if any of the
following factors changes:
S D Stock Price
t D Time
D Volatility
r D Interest Rate
2. Form an approximate replicating portfolio for the

written call option.
The value of this portfolio should change by
about the same amount as that of the option.
At least for small changes in the factors.
But how do we figure out how sensitive the option is

to the factors?

The Greeks
To construct the approximate replicating portfolio, we

have to know how much the value of the option
changes as the various factors change.
That is, the sensitivity of the call to each factor.
Using calculus (i.e., a linear approximation), for
small changes in the factors, the value of the call
option changes by:
@C 1 @2 C 2 @C @C @C
dC D dS C 2
(dS ) C dt C d C dr,
@S 2 @S @t @ @r

Delta Gamma Theta Vega Rho
or, using the symbols , , , and ,
2
dC D c dS C 12 c (dS ) C c dt C c d C c dr.
These Greeks characterize the market risk

associated with the option.

II. Example: Stocks, Bonds, and Forwards

Before we consider the sensitivity of an options
price to each of the factors that determine an
options value, well do some simpler securities.
To get a feel.
First, what are , , , and for a stock?
@S t
S D D 1
@S t
@S
S D D 0
@S t
@S t
S D D 0
@t
@S t
S D D 0
@
@S t
S D D 0.
@r

What about a bond?

r (T t)
Bt,T D e , so
@Bt
B D D 0
@S t
@B
B D D 0
@S t
@Bt
B D D rBt,T
@t
@Bt
B D D 0
@
@Bt
B D D (T t )Bt,T .
@r
B D rBt,T > 0 )
Bond becomes more valuable as time passes.
B D (T t )Bt,T < 0 )
Bond looses value when interest rates rise.
Note: B D DB Bt,T .

What about a forward contract?

r (T t)
Replication ) f t D S t Ke , so
@f t
f D D 1
@S t
@f
f D D 0
@S t
@f t r (T t)
f D D rKe
@t
@f t
f D D 0
@
@f t r (T t)
f D D (T t )Ke .
@r
A long forward position is worth more (ceteris

paribus)
If the underlying goes up.
If interest rates rise.
With more time to maturity.
Note: f D 1 and f D 0 explains why we can

replicate a forward statically.

III. The Greeks for European Options
How does the price of a derivative change when we

vary one factor and hold all others fixed?
Delta ()
Delta measures a derivatives sensitivity to the
price of the underlying security.
@C
c D D N(d1) > 0
@S
@P
p D D N( d1 ) < 0.
@S
Note that:
c ! 0 as S ! 0
c ! 1 as S ! 1
Important: In the Black-Scholes model, delta tells

us how many shares of the stock to buy for the
replicating portfolio.

What does c look like?
Delta vs. Underlying price

T = 1 week, 1 month, and 1 quarter
Delta HDL
1
0.8
0.6
0.4
0.2
Spot HSL
60 80 100 120 140 160
Delta as a function of the spot price of the underlying, for

three different time-to-expirations [T D 0.02 (solid line),
T D 0.0833 (dashed line) and T D 0.25 (dotted line)].
Figure depicts the case when K D 100, D 0.56 and
r D 0.05.

How about c and moneyness?
Delta vs. Time-to-Expiration

ITM, ATM, OTM
Delta HDL
1
0.8
0.6
0.4
0.2
Time HTL
0.1 0.2 0.3 0.4 0.5
Delta as a function of time-to-maturity, for three different

levels of moneyness [K D 100 (solid line, ATM), K D
90 (dashed line, ITM) and K D 110 (dotted line, OTM)].
Figure depicts the case when S D 100, D 0.56 and
r D 0.05.

Gamma ( )
Gamma measures a derivatives convexity.
@c
c D
@S
@d1 0 N 0 (d1)
D @S
N (d1) D p > 0
S T t
@( d1)
p D @S
N 0 ( d1) D c.
Note that:
! 0 as S ! 0
! 0 as S ! 1
is high when S K.
What does gamma tell us?

It tells us how much we gain as the
underlying rises.
It also tells us how quickly a delta-hedged
derivative becomes unhedged.

Gamma vs. Underlying price

Gamma HGL
0.05
0.04
0.03
0.02
0.01
Spot HSL
80 100 120 140
Gamma as a function of the spot price of the underlying,

for three different time-to-expirations [T D 0.02 (solid
line), T D 0.0833 (dashed line) and T D 0.25 (dotted
line)]. Figure depicts the case when K D 100, D 0.56
and r D 0.05.

Gamma vs. Time-to-Expiration

ATM, OTM, ITM
Gamma HGL
0.035
0.03
0.025
0.02
0.015
0.01
0.005
Time HTL
0.1 0.2 0.3 0.4 0.5
Gamma as a function of time-to-maturity, for three

different levels of moneyness [K D 100 (solid line, ATM),
K D 80 (dashed line, ITM) and K D 120 (dotted line,
OTM)]. Figure depicts the case when S D 100, D 0.56
and r D 0.05.

Theta ()
Theta measures the derivatives sensitivity to the
passage of time. It captures time-decay.
@C
c D
@t
@ r (T t)

D @(T t)
SN(d1) Ke N(d2)
@N(d1 ) r (T t) @N(d2 ) r (T t)
D S @(T t)
C Ke @(T t)
rKe N(d2)
This can be simplified using

p
(d2 C T t)2 =2
0 Se
SN (d1) D p
2
p
0 ( T t )d2 2 (T t)=2
D SN (d2)e
r (T t)
D Ke N 0 (d2)
and
p
@ (d1 d2) @ T t
D D p
@(T t) @(T t ) 2 T t

Taken together, these imply
N 0(d1 )S r (T t)
c D p rKe N(d2)
2 (T t )
< 0.
c < 0 ) the value of a call decreases as time

goes by, ceteris paribus.
As time-to-expiration decreases:
The variance of the stock price at maturity
decreases.
Less value in the right to not exercise.
The time discounting of the exercise price
decreases.
Expected cost of exercise is higher.
Important: the fact that c is negative does not

imply that the call price is expected to fall.
Remember, the stock price, on average, rises
over time.

By put-call parity,
P D C f,
we have
@(C f)
p D
@t
@f
D c C
@(T t )
N 0 (d1) S r (T t)
D p C rKe N( d2 ).
2 (T t )
The first term is again because the variance of

the stock price at maturity decreases as time-to-
maturity decreases.
The second term is positive.
The PV of the strike grows over time.
I.e., with less time-to-maturity.
Put receive the strike, so this tends to make the
put more valuable as time passes.

Theta vs. Underlying price

Theta HQL
Spot HSL
80 100 120 140 160 180
-20
-40
-60
-80
Theta as a function of the spot price of the underlying, for

r D 0.05.

Theta vs. Time-to-Expiration

ATM, OTM, ITM
Theta HQL
Time HTL
0.1 0.2 0.3 0.4 0.5
-10
-20
-30
-40
-50
Theta as a function of time-to-maturity, for three different

r D 0.05.

Vega ()
Vega measures the derivatives sensitivity to the
volatility of the underlying security.
Youll occasionally see it called Kappa ().
@C p
c D DS T t N 0 (d1) > 0
@
@P
p D D c
@
Note that:
0 for S K
is largest for S K e r (T t)
0 for S K
Important: Vega is important to traders who worry

about changes in the volatility of the underlying
security.

Vega vs. Underlying price

Vega HL
20
15
10
Spot HSL
80 100 120 140 160 180 200
Vega as a function of the spot price of the underlying, for

r D 0.05.

Vega vs. Time-to-Expiration

ATM, OTM, ITM
Vega HL
17.5
15
12.5
10
7.5
5
2.5
Time HTL
0.05 0.1 0.15 0.2
Vega as a function of time-to-maturity, for three different

r D 0.05.

The Gamma-Vega Relationship

Remember:
N 0 (d1)
c D p
S T t
So:
p
c D S T t N 0 (d1)
D S 2(T t) c
or
c
D S 2(T t)
c
They always come together

Closely related; sensitivities to expected and
realized volatilities
Come in fixed proportion, for a given series
Calender spreads allow you to bet more on one
than the other

Rho (c )
Rho measures the derivatives sensitivity to the
risk-free interest rate.
@ r (T t)

c D @r
SN(d1) Ke N(d2)
D S @N(d
@r
1)
Ke r (T t) @N(d2 )
@r
r (T t)
C (T t )Ke N(d2).
Now
@N(d1 ) @d1 0
@r
D @r
N (d1)
p
@N(d2 ) @(d1 T t) 0
@r
D @r
N (d2 )
@d1 0
D @r
N (d2)
and
r (T t)
SN 0(d1) D Ke N 0 (d2).

So
r (T t)
c D (T t )Ke N(d2) > 0.
Put-call parity gives
r (T t)
@(C S C Ke )
p D
@r
r (T t)
D c (T t )Ke
r (T t)
D (T t )Ke N( d2 ) < 0.
The value of the call always goes up with the

interest rate.
The P V of S (T ) is always S (t ).
The P V of K drops.
The opposite is true for puts.

The value of a put falls with the interest rate.

Rho vs. Underlying price

Rho HL
20
15
10
Spot HSL
80 100 120 140 160 180
Rho as a function of the spot price of the underlying, for

r D 0.05.

Rho vs. Time-to-Expiration

ATM, OTM, ITM
Rho HL
25
20
15
10
Time HTL
0.1 0.2 0.3 0.4 0.5
Rho as a function of time-to-maturity, for three different

r D 0.05.

Other Greeks
Much less common; just mentioning their existence

Lambda
Delta per dollar invested
c
c D
C
Volga (or Vega-Gamma)

Second-order sensitivity to volatility
@2 C @c
D
@ 2 @
Vanna
Sensitivity of Delta to volatility
@2 C @c
D
@ @S @
Moneyness changes with underlying price, and

implied volatilities change with moneyness

IV. The Gamma-Theta Relationship
Remember the Black-Scholes partial differential

equation:
1 2 2 @2 C @C @C
2
S @S 2 C rS @S
C @t
rC D 0.
Using the Greeks we can rewrite this as
1 2 2
2
S c C rSc C c rC D 0.
That is, the Black-Scholes PDE implies a relation

between C , , , and for a European call
option.
They are not determined independently.
This is true in general, not just for calls.
How can we interpret this constraint?

First, rewrite the constraint as
rC D rSc C 12 2S 2 c C c .
Now remember: r C is the expected, risk-neutral

yield to the call.
Here yield = price rate of return.
The equation says that yield comes from three

sources.
If you own a call youre:
Long the underlying stock.

And earning a return on that.
Youre also Earning c .

Because youre long volatility.
And youre Paying c .

Remember: c < 0.
Time-to-expiration runs backwards.

rC D rSc C 12 2S 2 c C c .
This equation also says that if two calls are:

1. Priced the same, and
2. Have the same sensitivity to the underlying,
I.e., if C D C 0 and C D C 0 , then:
1 2 2 1 2 2
2
S c C c D 2
S c0 C c 0 .
That is, the call with the higher Gamma also has
a higher Theta.
You pay for Gamma by taking on Theta.
Traders care about this!

A lot.
Having this answer in an interview is the kind of
thing that can get you a job.

It also gives us another way to understand this:
Theta vs. Time-to-Expiration

ATM, OTM, ITM
Theta HQL
Time HTL
0.1 0.2 0.3 0.4 0.5
-10
-20
-30
-40
-50
Theta as a function of time-to-maturity, for three

different levels of moneyness. Solid line, ATM: K=S D
1; dashed line, ITM: K=S D 0.8; dotted line, OTM:
K=S D 1.2. Other parameters: D 0.56 and r D 0.05.
How so?
Well what happens to Gamma ATM, ITM, and
OTM as T ! 0?

V. Popular Options Strategies and the Greeks
We can also recast option portfolio strategies in

terms of the Greeks.
Traders tend to think about them this way.
For example, what are you buying when you buy

a straddle?
That is, when you buy both a put and a call with
the same strike.
py g ( ) y
Straddle:
C=f(S,t) ATM CALL + ATM PUT
S = 100 Profit
K = 100 (BUY ATM CALL @ $18.84)
(BUY ATM PUT @ $5.80)
t =1
r = 1.15
25
d = 1.00
V = . 3
50 75 125 150
Future Asset Price
-25 Strategy:
Strategy: Believe
Believevolatility
volatilityof
of
Straddle Value = $18.84 + $5.80 = $24.64 asset
asset price will be high,but
price will be high, buthave
have
no
noclue
clueabout
aboutdirection.
direction.
Loss

Youre not buying Delta.

At least not very much:
pCc D c C p
D N(d1 ) N( d1) 0.
2=2)T
pCc D 0 if d1 D 0 , K D Se (r C .
But youre definitely buying Gamma.
pCc D c C p D 2 c.
And the Gamma of the call is high, if its near the

money.
Youre paying for it with Theta.

Strike-discounting isnt the problem.
Youre paying on the put, earning on the call.
But the premia on both options shrinks with time.
Each moment, your exposure to Gamma costs
you Theta.

What happens to the straddle price as (T t ) ! 0?

Assuming everything else is unchanged.
Straddle Price
T = 1 day, 1 week, and 1 month
Price H$L
20
15
10
Spot HSL
90 100 110 120
Straddle prices (P100 CC100) as a function of the spot price

of the underlying, for three different time-to-expirations
[T D 0.004 (solid line), T D 0.02 (dashed line) and
T D 0.0833 (dotted line)]. Figure depicts the case when
D 0.56 and r D 0.05.

Butterfly spreads do more or less the opposite.

BS: Buy one ITM, sell two ATM, buy one OTM.
But near the money:
Delta is linear w.r.t. moneyness (more or less).
Gamma is convex w.r.t. moneyness.
Delta HDL Gamma HGL

1
0.05
0.8 0.04
0.6 0.03
0.4 0.02
0.2 0.01
Spot HSL Spot HSL

60 80 100 120 140 160 80 100 120 140
That is,
1
K 2
(K C KC )
1
K > 2
( K C KC ) ,
so
BFS D K 2K C KC 0
BFS D K 2 K C KC < 0.

What happens to the Butterfly price at the central

strike as (T t ) ! 0?
Assuming everything else is unchanged.
Butterfly Price
T = 1 day, 1 week, and 1 month
Price H$L
10
Spot HSL
85 90 95 100 105 110 115 120
Butterfly prices (C90 2C100 C C110) as a function of the

spot price of the underlying, for three different time-to-
expirations [T D 0.004 (solid line), T D 0.02 (dashed line)
and T D 0.0833 (dotted line)]. Figure depicts the case
when D 0.56 and r D 0.05.

VI. Risk Management

A. Portfolio Hedging
The basic idea of portfolio hedging is that the
value of a portfolio can be made invariant to the
factors affecting it, such as S , and r .
For example, suppose a portfolio consists of
three assets:
V D n1 A1 C n2 A2 C n3 A3
where:
V is the value of the portfolio,
ni is the number of shares of asset i, and
Ai is the market value of one share of asset i.
Then the sensitivity of the portfolio to some

arbitrary factor, x, is
@V @A1 @A2 @A3

D n1 C n2 C n3 .
@x @x @x @x

The objective of x-hedging is to pick the ni such

that the value of the portfolio stays constant
when x changes.
That is, pick n1, n2, and n3 so that:
@V @A1 @A2 @A3

D n1 C n2 C n3 D 0.
@x @x @x @x
Then the value of the portfolio stays approximately

constant when x changes by a small amount:
@V
dV D dx 0.
@x
Important: It takes n securities to hedge against

n 1 sources of uncertainty.
For example, with two assets you can only
hedge one risk.
E.g., you could pick the relative weights so that
the portfolio is Delta-neutral.
All the other exposures are determined by
these weights.

B. Delta Hedging
A portfolio is Delta neutral (i.e., Delta hedged) if

the of the portfolio is zero.
For example, take our portfolio of three assets,
and let x D S :
@V
portfolio D
@S
@A1 @A2 @A3
D n1 C n2 C n3
@S @S @S
D n1 1 C n2 2 C n3 3.
The portfolio will be Delta-hedged if we pick the

ns so that this is zero.
Then the portfolio value will be insensitive to
small changes in S :
dV portfolio dS D 0.

More concretely:
Remember the call you wrote for Goldman-
Sachs:
S D 50
K D 50
10
T t D 52
D 0.50
r D 0.03.
Questions: how many share of the stock should

we buy to Delta hedge the option?
Were short the call, and c D 0.554.
S of a share is one, so we buy nS shares such
that:
nS 1 0.554 D 0.
So, we buy nS D S D 0.554 shares of the stock.

C. Gamma Hedging
A portfolio is Gamma neutral (i.e., Gamma

hedged) if the of the portfolio is zero.
Take the portfolio of three assets and let x D S :
@2 V
portfolio D
@S 2
@portfolio
D
@S
@1 @2 @3
D n1 C n2 C n3
@S @S @S
D n1 1 C n2 2 C n3 3.
Question:
If a portfolio is already Delta hedged, so its value
stays approximately constant for small changes in
S , why do we want to Gamma hedge it?

Example continued ...

We just learned that the portfolio
1. Short the ATM call, and
2. Long 0.554 shares of the stock,
is Delta hedged.
How stable is the value of this portfolio if S

changes?
Small change in S:
Suppose S increases from 50 to 51.
C (50, 50, 10
52
, 0.50, 0.03) D 4.498
C (51, 50, 10
52
, 0.50, 0.03) D 5.070.
Then 0.554(51 50) (5.070 4.498) D 0.018.

A loss of less than 2 cents for a $1 increase in
the stock price.
Not too bad.
But what about bigger moves in the underlying?

Large change in S :
C (50, 50, 10
52
, 0.50, 0.03) D 4.498
C (60, 50, 10
52
, 0.50, 0.03) D 11.541.
Then 0.554(60 50) (11.541 4.498) D 1.54.

A loss of $1.54 for a $10 increase in the stock
price.
Not so good. Our hedged position still had
an effective 15% exposure the large move in
the underlying.
Lesson from the Example:

Delta hedging works well for small changes in S
only.
Gamma hedging can improve the quality of the
hedge.

To understand why, look at the Taylor series

expansion for the change in the call price
2
C (S C dS ) C (S ) c dS C 12 c (dS )
D 0.554 dS C 0.018 (dS )2.
Buying 0.554 shares hedges the first term.

Were still exposed to the second term.
Wed need to Gamma hedge as well to
eliminate that exposure.
For the large change in S (dS D 10), the second
term is $1.80, which explains our $1.55 loss.
Any discrepancy is due to the missing 3rd-,
4th-, and higher- order terms.
Questions:
Is Gamma hedging alone more effective than
Delta hedging alone?
Can we use stock to Gamma hedge an option?

D. Simultaneous Delta and Gamma Hedging

What if we wanted to hedge our writhen call such
that our net position was both Delta-neutral and
Gamma-neutral?
For that ATM call 1 D 0.554 and 1 D 0.0361.
We need another asset

One that has Gamma.
So any call should do
Well consider the call struck at 55.
Delta-hedging requires that
nS S C nC55 C55 C nC50 C50 D 0.
Gamma-hedging requires that
nS S C nC55 C55
C nC50 C50
D 0.

We already know
C50 D 0.554
C50
D 0.0361.
And S D 1, S D 0.
Black-Scholes gives
C55 D 0.382
C55
D 0.0348.
Finally, nC50 D 1, so need to buy nS shares of

the stock and nC55 calls at 55 such that:
nS C 0.382 nC55 0.554 D 0
0 C 0.0348 nC55 0.0361 D 0.
Solving these yields nS D 0.158 and nC55 D 1.037.

How stable is the value of this portfolio to changes

in S ?
Small change in S:
C50(51) C50(50) D 5.067 4.498

D 0.569
C55(51) C55(50) D 3.002 2.602
D 0.400
and
0.158 1 C 1.037 0.400 1 0.569 D 0.001.
The value of the portfolio changes (increases)

by less than 0.1 cent.
Thats pretty good hedging.

Large change in S :
C50(60) C50(50) D 11.581 4.498

D 7.084
C55(60) C55(50) D 8.104 2.602
D 5.501
and
0.158 10 C 1.037 5.501 1 7.084 D 0.201.
The value of the portfolio changes (increases)

by 20 cents.
Thats much less than a change of $1.55
change for the Delta hedged portfolio.
Important: We needed three securities to form a

portfolio hedged in both Delta and Gamma.
In general we need n securities to form a
portfolio that is insensitive to small variations in
n 1 factors.

E. Theta, Vega, and Rho Hedging
These dont get worried about as much

Theyre still important, but not as important.
The mechanics of these hedging strategies are

similar to Delta or Gamma hedging.
For example, a portfolio is Theta hedged, or is
Theta neutral, if its is zero.
Some questions:
How does the of a portfolio relate to the s of

the securities that form the portfolio?
Can a bond be used for Theta hedging?
Can a stock be used to Theta hedge an option?

VII. The Cost of Greeks
We can construct pure exposures to individual

Greeks
By hedging all the other risks away
This allows us to price the exposures

Figure what it costs to take on a pure exposure
to a given Greek
The easiest Greek to price is delta

How do you get a pure exposure to ?
Whats the cost of a unit exposure to ?
The underlying is a pure exposure to delta

So cost of a unit exposure:
P D S

Rho is also easy to price

What does duration cost?
Nothing!
Remember, for a bond B D B D B D 0, and
@Bt
B D D rBt,T
@t
@Bt
B D D (T t )Bt,T
@r
So buy $1 of a long bond, sell $1 of a short bond

Its free
l=s D l=s D l=s D 0, and
l=s D r r D 0
l=s D (Tl t ) C (Ts t)
D (Tl Ts )
So P D 0

Now its easy to price theta
Again, for a bond B D B D B D 0, and
@Bt
B D D rBt,T
@t
@Bt
B D D (T t )Bt,T
@r
Rho is free
So buy a bond, at a cost of Bt,T

Hedge the Rho risk
using a zero-cost portfolio of bonds
Hedging Rho is free
Your pure theta exposure of rBt,T cost you Bt,T
Unit price is (price paid) / (total exposure), so
Bt,T 1
P D D
rBt,T r

Gamma and Vega are slightly harder

Lets start by summarizing what we know
Cost of , , and :
P D S
P D 0
P D 1=r
r (T t)
C D SN(d1) Ke N(d2 ) and
c D N(d1)
N 0(d1)
c D p
S T t
N 0 (d1)S r (T t)
c D p rKe N(d2)
2 (T t )
c D S 2(T t) c
r (T t)
c D (T t )Ke N(d2)
Cost of a delta/rho/theta-hedged call?

Cost and Greeks of the hedged call:
P C P C P C P C
r (T t)

D SN(d1) Ke N(d2) SN(d1)
!
0
1 N (d1)S r (T t)
p rKe N(d2)
r 2 (T t )
N 0(d1)S
D p
2r (T t )
and
P D 0
N 0 (d1)
P D p
S T t
P D 0
P D S 2(T t) c
P D 0

Now note that

N 0(d1)S
p
P 2r (T t) 2S 2
D D
P N 0(d1 )
p 2r
S T t

2S 2
i.e., P D 2r P
This is independent of all contractual parameters

$1 of any delta/rho/theta-hedged call gives you
the same amount of gamma: P =P D 2r= 2S 2
So a long/short portfolio of delta/rho/theta-hedged
calls is gamma-neutral
Its also delta/rho/theta-neutral
Its not generally Vega-neutral
Unless same maturity on both sides
I.e., pure Vega-exposure is free ) P D 0
So ame equation gives us the price of gamma:
P 2S 2
P D D
P 2r

Summarizing:
P D S
2S 2
P D
2r
P D 0
P D 0
P D 1=r
So the value of any derivative V on S , in terms of

its exposures to the risk factors, is
V D P C P C P C P C P
2 2
S 1
D S C 2r C r
We can also write this as
rV D rS CS C 12 2S 2CS S C C t
The Black-Scholes PDE!

VIII. Other Risk Management Approaches
Stop-Loss Rules.
Scenario Analysis:
1. Monte Carlo Simulations.
2. Stress Testing.
3. Value at Risk (VAR).

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Lecture 11:

The Greeks and Risk Management

This lecture studies market risk management from

Traders who write derivatives must hedge their risk

Example: Suppose youre trading options for

 The underlyings trading at $50, and  D 50%.

Black-Scholes tells you that the call option is worth

 Buy the same option for $4.50 elsewhere.

Bus 35100 Page 2 Robert Novy-Marx

Question 1 : can you really perfectly replicate the

 You can if both:

 You can if both:

But in the real world:

 We cant trade continuously.

Bus 35100 Page 3 Robert Novy-Marx

Question 2: So what should you do, if you cant

2. Form an approximate replicating portfolio for the

But how do we figure out how sensitive the option is

Bus 35100 Page 4 Robert Novy-Marx

To construct the approximate replicating portfolio, we

or, using the symbols , , ,  and ,

These Greeks characterize the market risk

Bus 35100 Page 5 Robert Novy-Marx

II. Example: Stocks, Bonds, and Forwards

 First, what are , , ,  and  for a stock?

Bus 35100 Page 6 Robert Novy-Marx

 What about a bond?

Bus 35100 Page 7 Robert Novy-Marx

 What about a forward contract?

 A long forward position is worth more (ceteris

Note: f D 1 and f D 0 explains why we can

Bus 35100 Page 8 Robert Novy-Marx

III. The Greeks for European Options

How does the price of a derivative change when we

Important: In the Black-Scholes model, delta tells

Bus 35100 Page 9 Robert Novy-Marx

 What does c look like?

Delta vs. Underlying price

Delta as a function of the spot price of the underlying, for

Bus 35100 Page 10 Robert Novy-Marx

 How about c and moneyness?

Delta vs. Time-to-Expiration

Delta as a function of time-to-maturity, for three different

Bus 35100 Page 11 Robert Novy-Marx

What does gamma tell us?

Bus 35100 Page 12 Robert Novy-Marx

 What does c look like?

Gamma vs. Underlying price

Gamma as a function of the spot price of the underlying,

Bus 35100 Page 13 Robert Novy-Marx

 How about c and moneyness?

Gamma vs. Time-to-Expiration

Gamma as a function of time-to-maturity, for three

Bus 35100 Page 14 Robert Novy-Marx

This can be simplified using

Bus 35100 Page 15 Robert Novy-Marx

 Taken together, these imply

 c < 0 ) the value of a call decreases as time

Important: the fact that c is negative does not

Bus 35100 Page 16 Robert Novy-Marx

 The first term is again because the variance of

Bus 35100 Page 17 Robert Novy-Marx

The underlyings trading at $50, and D 50%.

Buy the same option for $4.50 elsewhere.

You can if both:

You can if both:

We cant trade continuously.

or, using the symbols , , , and ,

First, what are , , , and for a stock?

What about a bond?

What about a forward contract?

A long forward position is worth more (ceteris

What does c look like?

How about c and moneyness?

What does c look like?

How about c and moneyness?

Taken together, these imply

c < 0 ) the value of a call decreases as time

Important: the fact that c is negative does not

The first term is again because the variance of

What does c look like?

How about c and moneyness?

What does c look like?

How about c and moneyness?

Put-call parity gives

The value of the call always goes up with the

The opposite is true for puts.

What does c look like?

How about c and moneyness?

Volga (or Vega-Gamma)

Remember the Black-Scholes partial differential

Using the Greeks we can rewrite this as

That is, the Black-Scholes PDE implies a relation

How can we interpret this constraint?

First, rewrite the constraint as

Now remember: r C is the expected, risk-neutral

The equation says that yield comes from three

If you own a call youre:

This equation also says that if two calls are:

Traders care about this!

It also gives us another way to understand this:

We can also recast option portfolio strategies in

For example, what are you buying when you buy

Youre not buying Delta.

But youre definitely buying Gamma.

Youre paying for it with Theta.

What happens to the straddle price as (T t ) ! 0?