Advanced Option Risk Management

Option Risk Management
Copyright 2000 2006 Investment Analytics
Agenda
Option sensitivity factors Delta
Delta hedging
Option time value Gamma and leverage Volatility sensitivity Gamma and Vega hedging
Copyright 2000-2006 Investment Analytics Advanced Option Risk Management Slide: 2
Option Sensitivity Factor

What affects the price of an option
the the the the the asset price, S volatility, interest rate, r time to maturity, t strike price, X
Copyright 2000-2006 Investment Analytics Advanced Option Risk Management
Slide: 3
Black-Scholes Equation
Consider delta-hedged option portfolio
Must grow at risk free rate, else arbitrage
Leads to following relationship:
V 1 2 2 V V + S + rS = rV 2 S S t 2
2
Theta
Gamma
Delta
Slide: 4
Option Greeks
Delta (price sensitivity)
change in option price due to change in stock price
Gamma (leverage)
change in delta due to change in stock price
Vega (volatility sensitivity)

change in option price due to change in volatility
Theta (time decay)

change in option value due to change in time to maturity
Option Delta
Key sensitivity dV/dS
Change in option value for infinitely small move In reality use: V/S Better still:
1 V V Delta = + + 2 S S
Slide: 6
The Delta of a Call Option

Delta changes as stock price changes
Gamma measures rate of change of delta
In the money Call Value Out of the money At the money 1
0.5 X Stock Price

Slide: 7
IBM Option Delta
Slide: 8
A New Look at Delta

Probability Delta = Probability of Option Finishing inthe-money
S X.e-rt Out-of-the-Money
Delta: At-the-Money
Probability
S = X.e-rt At-the-Money
Delta: In-The-Money
Probability Delta 1
X.e-rt
S
Slide: 11
In-the-Money
Delta and Derivatives

Forward FX Contracts
F = e(r-rf)t S So delta of forward is e-rft
Stock index with dividend yield d

Delta = e-dt
Slide: 12
Delta and Volatility

How does (future) volatility affect delta? Example, Stock $100, 25% vol
$100 1-year Call, delta = 0.63 $100 1-year Put, delta = -0.37
Slide: 13
Call Delta and Volatility
Slide: 14
Put Delta and Volatility
Slide: 15
Delta and Volatility

ITM/ATM Call Option
Delta will fall with rising volatility Due to fatter tails, probability of finishing OTM increases
OTM Call Option

Delta will increase with volatility Due to fatter tails, probability of finishing ITM increases
Option Value
Intrinsic Value
Asset Price Strike Price Interest rates
Time Value
Time to Expiration Volatility
Slide: 17
How Time Value Decays

9 months 6months 3 months
Premium
Expiration
Stock price
Strike Price
Time Decay (Theta)

Decay Acceleration
Premium
0
Time Value of IBM Option
Slide: 20
IBM Option Theta
Slide: 21
Theta Adjustments
Modified Theta
Takes account of rolldown on volatility curve Daily loss of value assuming volatility is at level with 1-day shorter expiration
Shadow Theta
Losses from decay are often compounded by drop in implied vol in quiet markets Shadow theta factors in expected changes in IV.
Slide: 22
Option Gamma
Change in Delta for small change in stock
Second derivative: 2V/S2 Rate of Acceleration of option value with price
Call and put options have positive gamma

Option delta becomes larger as stock appreciates Becomes smaller (more negative) as stock declines
Gamma Formula
N (d1 ) = S t
1 x2 / 2 N ( x) = e 2
ln(S / X ) + ( 2 / 2)t d1 = t
IBM Option Gamma
Slide: 25
Lab: Leverage
An Experiment:
Assume stock $100 Risk free rate 10%, volatility 25% Call option, strike price 100 (at the money)
Leverage:
If stock moves by $5, how much does option value change?
Slide: 26
Solution: Leverage
Maturity 1.00 0.50 0.25 0.10 0.01 Call S=100 12.34 8.26 5.60 3.40 1.02 Prices S=105 15.66 11.48 8.80 6.69 5.07 Return (%) 27% 39% 57% 97% 396% Gamma 0.015 0.022 0.032 0.050 0.160
NOTES: Col 2 is option value with stock price = 100 Col 3 is option value with stock price = 105 Col 4 is Leverage: (C1 - C2)/C1
Time vs Leverage
Slide: 28
Gamma Characteristics
For ATM options Gamma is max nearer to expiration For OTM options Gamma is max further away from expiration
Slide: 29
Up- and Down- Gamma

Gamma is not symmetric
Up-Gamma: change in delta for small gain in stock price Down-Gamma: change in delta for small loss in stock price
Beware averaging!
Some high risk positions have large +ve up-gamma and large ve down-gamma
Gamma and Volatility
Slide: 31
Shadow Gamma
Volatility adjusted Gamma Up- Shadow Gamma
S , ( + d ) [S , ] = + (S S )
+ +
Down Shadow-Gamma
S , ( + d ) [S , ] = (S S )
Lab: Shadow Gamma

Shadow Gamma
1500 1000 500 P/L 0 -500 -1000 -1500 Stock Price 80 84 88 92 96 100 104 108 112 116 120 Gamma Shadow Gamma
Slide: 33
Delta and Gamma Bleed

Delta Bleed
Change in Delta per day
OTM (ITM) options move further OTM (ITM) with time Reduces (increases) delta
Gamma Bleed
Change in Gamma per day
Increases for ITM/ATM options Decreases for OTM options
Delta Bleed ATM
Slide: 35
Delta Bleed - ITM
Slide: 36
Gamma Bleed ITM
Slide: 37
Gamma Bleed OTM
Slide: 38
Alpha: Gamma Rent

Theta per Gamma ratio Low alpha means taking little theta risk for the gamma Alpha = (modifed Theta) / (shadow) Gamma Theta = - 2S2 Alpha = - 2S2
Volatility Greeks
Vega - sensitivity to implied volatility Gamma - sensitivity to actual volatility Example: Weather
People carrying umbrellas (implied risk of rain) = Vega Rain (the wet stuff) = Gamma
Implied volatility
estimated s.d. implied by option prices by B-S model markets estimate of current volatility
Vega
Measures change in option value for small change in implied volatility
V = S t N (d1 ) 1 x2 / 2 N ( x) = e 2
Slide: 41
Vega Characteristics
Call and put options have positive Vega
Increase in value as implied volatility increases
Vega changes with underlying stock

Highest for ATM options
Most sensitive to changes in implied volatility
Most Vegas decrease with time

(except knock-outs and other exotics)
IBM Option Vega
Slide: 43
Vega and Time

Vega and Time
50
40
30
Vega
20
10
1.0 0.7
0 60 80 100 120 140 0.1
0.4 160
Time
Asset
Slide: 44
Vega Convexity
Nonlinearity of payoff Vega convexity 2V /2 Vega is a non-linear function of Price
Linear for ATM options Non-linear for ITM/OTM options
Payoff like an option on volatility
Vega Convexity
Call Option Price and Vega
40 30 Price 20 20 10 0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 10 0 50 40 Vega 30
Volatility
Slide: 46
Lab: Option Sensitivities
Slide: 47
Solution: Option Sensitivities

Delta Gamma
Vega
Theta
Slide: 48

Delta
Short-dated, ATM options on less volatile stock are more sensitive
Gamma
Greatest for short-dated ATM options on less volatile stock
Slide: 49

Vega
Long-dated, ATM options on less volatile stock more volatility sensitive
Theta
Short-dated ATM options on more volatile stock experience greatest rate of decay
Slide: 50
Volatility Smiles & Surfaces

Implied volatilities of options with different strikes varies
Inconsistent with Black-Scholes Implies volatilities of OTM options typically greater than ATM options
Smile: Plot IV vs. Strike

Shows smile effect
Surface: Plot IV vs. Strike & Maturity

Volatility Smile Example
Slide: 52
Volatility Surface Example
Slide: 53
Forward Volatility
2 1
2 F 2 2
T0
T1
T2
2 F = [( T2 T1 ) 2 ( T1 T0 ) 1 ] / ( T2 T1 ) 2
Market focus on spot volatility Creates arbitrage opportunities in forward market

Minor fluctuations in spot volatility create large swings in forward volatility
Slide: 54
Forward Volatility Curve

Volatility Curve
70% 60% 50% 40% 30% 20% 10% 0% 30 60 90 120 150 180 210 240 270 300 330 360 Spot Forward
Slide: 55
Curve Movement
Parallel Steepening/Flattening Convexity changes
Slide: 56
Lab: YAHOO
Construct implied volatility smile & surface
Slide: 57
Solution: YAHOO
73% 73%
72%
72%
71%
71%
95 100 105 110 115 0.07 0.15 0.32 0.57
70%
Slide: 58
Solution: YAHOO
73%
73%
72%
72%
71%
71% 95 100 105 0.32 110 0.15 115 0.07 70% 0.57
Slide: 59
Simple Gamma Hedging

Suppose unhedged position = one call
You can make it delta neutral But this only works for small changes Need to eliminate gamma risk too
How do you make it Delta & Gamma neutral?

Cant use stock: gamma is zero Must use other options, O1 and O2
Solve:
m1 + n2 = 0 m1 + n2 = 0
Slide: 60
Simple Vega Hedging

Make a portfolio Delta-Vega neutral Again, use other options Solve: m1 + n2 = 0 mV1 + nV2 = 0
Slide: 61
Lab: Greek Hedging

Excel: Workbook
Worksheet: Greek hedging
Sensitivity:
Check how position value, delta changes with stock price Check how position value changes with volatility
Hedging:
Gamma hedge the given portfolio Check sensitivity of position to stock price
Use Solver
Greek Hedging Using SOLVER
Slide: 63
Solution: Greek Hedging

Portfolio Hedge Net Position Target Abs. Position Quantity 0.0 0.0 99.5 2.0 0.1 0.0 -0.1 -0.7 75.3 0.0 Value -493.9 493.9 -0.0 0.0 0.0 Type C C C C C P P P P P Position Delta Gamma 9.2 -15.9 -9.2 15.9 -0.1 -0.0 0.0 0.0 0.1 0.0 Strike 35 40 45 50 55 35 40 45 50 55 Maturity 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 Vega -1,169.8 1,168.1 -1.7 1,169.8 1.7 Price 10.44 5.53 1.55 0.14 0.00 0.00 0.04 0.99 4.52 9.32 Theta 282.2 -281.6 0.6 282.2 0.6 Delta 1.00 0.97 0.59 0.10 0.00 0.00 -0.03 -0.42 -0.90 -1.00 Gamma 0.000 0.020 0.119 0.053 0.004 0.000 0.020 0.119 0.053 0.004 Stock Volatility Risk Free 45 14.0% 5.0%
Vega 0.01 1.49 8.77 3.90 0.27 0.01 1.49 8.77 3.90 0.27
Theta -1.73 -2.33 -3.70 -1.31 -0.08 0.00 -0.35 -1.47 1.16 2.63
Slide: 64
Modified Vega
Measures sensitivity to nonparallel changes in volatility curve n V * = iVi
i =1
Vi are vegas in maturity buckets i = 1 , . . ., n i are weights to be determined
Slide: 65
Theoretical Weighting
Square root time rule Start with e.g. 30-day exposure Weight exposures at other maturities by (30/t)1/2 Example: 120 day Vega is weighted by (30/120)^0.5 = 0.5 So $1M Vega risk in one month is equivalent to $2M exposure at 120 days
Forward Volatility Analysis

Separate Vega risk into forward buckets Example:
0 30 days 30 60 days 60 90 days 90 180 days 180 360 days
Slide: 67
Forward Volatility Analysis

Bucket volatility & correlation
Estimate volatility of volatility for each forward bucket Estimate volatility correlations between forward buckets
Use these to weight the exposures in each forward bucket and compute P/L
Slide: 68
Value at Risk Models

Delta-Normal
Simple, linear model uses derivatives delta Ignores high-order effects
Non-Linear Model
Makes adjustments for non-linear effects (Gamma risk) Important for derivatives portfolios
Slide: 69
The Delta-Normal Model

VAR =
Market Value x Confidence Factor x Volatility x Delta
Same as standard model, just incorporating delta

NB: stock portfolio: delta = 1
A simple linear function of delta Assumes that returns are normally distributed If necessary, adjust volatility by T1/2 for appropriate holding period, as before
Derivative Portfolio VaR Example

Long S&P100 OEX index calls
Market value $9.45MM Daily volatility 1% Option delta 0.5 Confidence level 99% (CF = 2.33)
VAR = $9.45 x 2.33 x .01 x 0.5 = $110,000

There is a 1% chance that the call portfolio will lose more that $110K in a day
Slide: 71
Options & VAR

A deep In-the-Money option
Has approximately same VAR as underlying stock
Assuming equal $ amounts invested in each
Only true for short-term holding periods Why? Answer:

Delta of ITM option ~ 1 For long holding period, delta bleed
VaR & Delta

1.00 0.90 0.80 0.70 0.60
VAR
0.50 0.40 0.30 0.20 0.10 0.00 150 146 142 138 134 130 126 122 118 114 110 106 102 98 94 90 86 82 78 74 70 66 62 58 54 50
At the Money
Moneyness Copyright 2000-2006 Investment Analytics Advanced Option Risk Management
Slide: 73
VaR and Delta

VAR increases with Delta
Minimum for OTM options, delta ~ 0 Maximum for ITM options, delta ~ 1 Changes most rapidly for
ATM options Short maturity options
because of Gamma
Slide: 74
Delta-Normal VaR: Equivalent Formulation

VAR = S x CF x x p
S CF p
= underlying (stock) price = confidence factor = volatility = Delta of portfolio
Slide: 75
VAR and Gamma

Gamma adjustment required for
ATM options Short-dated options
Gamma risk is minor for

Deep ATM/OTM long dated options Short holding periods
Slide: 76
VAR Formula Gamma Adjusted

VaR =
S CF
S x CF x x [p2 + 1/2 (S x x )2]1/2

= = = = underlying stock price confidence factor volatility Gamma = Delta of portfolio
Note: same as Delta-Normal model when = 0

VAR & Gamma Risk Example

Long 1000 ATM calls
Stock price is $50 Daily volatility 1.57% (25% annual) Portfolio delta 700 Gamma is 27.8 Confidence level 95% (CF = 1.65)
VAR = $50 x 1.65 x 0.0157 x [7002 + 1/2(50 x 0.0157 x 27.8)2]1/2 = $907

There is a 5% chance that the call portfolio will lose more that $907 in a day
Limitations of Delta-Gamma Normal Model

Major sources of error:
Gamma changes over time (bleed)
Gamma increases as maturity approaches High-order effect produces very rapid changes in VaR
Gamma-adjusted VaR non-Normal

Right-skewed distribution Overtstates true VaR
Slide: 79
Zangaris Moment Adjustment

Adjust Normal confidence parameter
Correction for skewness & kurtosis
2 3 3 (1 / 6)( Z 1) + (1 / 24)( Z 3Z ) (1 / 36)(2 Z 3Z )( ) 2
Z is the distributions lower -percentile is the skewness is the kurtosis

Adjusting for Fat Tails

Standardized residual process
R r / t = t
t ~ Normal(0, 1)
Zangaris Normal Mixture Approach
R r / t = 1,t + t 2,t
t is binary variable, usually 0, sometimes 1 2,t ~ Normal (t, 2t)
Zenaris GED
Generalized Error Distribution
f ( t ) =
e
2
(1/2)| t / |
(1+1/ )
(1/ )
= [2 (2/ )(1/ )/3]1/2
Normal distribution when v = 2 Probability of extreme event rises as v gets smaller

Model Testing
Back testing recommended by Basle Committee Check the failure rate
Proportion of times VaR is exceeded in given sample Compare proportion p with confidence level
Problem:
Hard to verify VAR for small confidence intervals
Need very many sample periods to obtain adequate test
Slide: 83
Failure Rates
Test Statistic: see Kupiec 1995
1 + 2Ln[(1-p)T-NpN] - 2Ln[(1-(N/T))T-N (N/T)N]
ChiSq distribution, 1d.f. N = # failures; T = Total sample size
Example: Confidence level = 5%

Expected # failures = 0.05 x 255 = 13 Rejection region is 6 < N < 21
If # failures lies in this range, model is adequate If N > 21, model underestimates large loss risk If N < 6, model overestimates large loss risk
Slide: 84
Additional Tests
Christofferson (1996)
Interval test for VAR Very general approach
Zangari Excessive Loss Test (1995)

Calculates expected losses in tail event
E [R t | R t < t ] = t f ( ) / F ( )
f and F are standard Normal density / Distribution fns Use t-test to compare sample mean losses against expected
Slide: 85
Lopez Probability Forecasting Approach

Most tests have low power
Likely to misclassify a bad model as good Especially when data set is small
Lopez Approach
Uses forecasting loss function
e.g Brier Quadratic Probability Score
QPS = 2 ( p tf I t ) 2 /T
t =1
Identifies true model in most simulated cases
ptf is forecast probability of event taking place in interval t It takes value 1 if event takes place, zero otherwise
Slide: 86
Empirical Tests
Zengari (1996)
Tested Standard Normal, Normal Mixture and GED VAR
12 FX and equity time series
All performed well at the 95% confidence level Normal Mixture ad GED performed considerably better at 99% confidence level
Conclusion
Both NM and GED improve on Normal VAR
Other Approaches to VAR

Historical Simulation Stress Testing Monte-Carlo Simulation
Slide: 88
Historical Simulation
Calculation
Calculate return on portfolio over past period Calculate historical return distribution Look at -1.65 point, as before
Pros & Cons

Does not rely on normal distribution Only one path (could be unrepresentative)
Stress Testing
Scenario approach:
Simulates effect of large movements in key financial variables
E.g. Derivatives Policy Group Guidelines

Parallel yield curve shifts +/ 100 bp Yield curve twist +/ 25 bp Equity index values change +/ 10% Currency movements +/ 10% Volatilities change +/ 20% of current values
Pros & Cons

More than one scenario Validity of scenarios is crucial Handles correlations poorly
Monte Carlo Simulation

Sometimes called full valuation method Widely applicable
Does not assume Normal distribution Handles all types of securities
Slide: 91
Monte-Carlo Methodology
Simulate movement in asset value
Repeat 10,000 times, get 10,000 future values Create histogram
Find cutoff value such that 95% of calculated values exceed cutoff
Cutoff value is the portfolio VAR

For given confidence level (95%) For given holding period
Generating Simulated Values

S = S0 x ( + )
S is change in value S0 is initial value is average daily return is daily volatility is random variable
Procedure:
Generate (random) Compute change in portfolio value Repeat many times (10,000+) Create a histogram of portfolio values
Example
Slide: 94
CrashMetrics
Different Approach
Assumes worst case scenario Examines behavior of assets in market crashes Finds optimal hedging strategy
Advantages:
Distribution-free Robust Works with complex derivative positions Static hedging at known cost
Lab: Implementing a Simple VaR Model

Implementing a VaR model:
Delta normal Delta-Gamma Monte-Carlo simulation
Hedging
Delta neutral Delta-Gamma
Worksheet: Risk Management

Summary: Option Risk Management

Option Greeks
Importance of interaction effects Bucketing techniques
Value at Risk
Severe limitations for option books
Crashmetrics
Free of most unrealistic assumptions
Slide: 97

Advanced Option Risk Management

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Option Risk Management

Copyright 2000 2006 Investment Analytics

Option Sensitivity Factor

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Leads to following relationship:

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Vega (volatility sensitivity)

Theta (time decay)

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

The Delta of a Call Option

0.5 X Stock Price

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

IBM Option Delta

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

A New Look at Delta

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Delta and Derivatives

Stock index with dividend yield d

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Delta and Volatility

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Call Delta and Volatility

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Put Delta and Volatility

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Delta and Volatility

OTM Call Option

Time to Expiration Volatility

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

How Time Value Decays

Time Decay (Theta)

Time Value of IBM Option

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

IBM Option Theta

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Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Call and put options have positive gamma

IBM Option Gamma

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Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Up- and Down- Gamma

Gamma and Volatility

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management Slide: 32

Lab: Shadow Gamma

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Delta and Gamma Bleed

Delta Bleed ATM

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Delta Bleed - ITM

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Gamma Bleed ITM

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Gamma Bleed OTM

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Alpha: Gamma Rent

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management

Vega changes with underlying stock

Most Vegas decrease with time

IBM Option Vega

Copyright 2000-2006 Investment Analytics Advanced Option Risk Management