Pricing and Hedging under the

Black-Merton-Scholes Model

Liuren Wu

Zicklin School of Business, Baruch College

Options Markets

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 1 / 36

Outline

1 Primer on continous-time processes

2 BMS option pricing

3 Hedging under the BMS model

Delta
Vega
Gamma

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The Black-Scholes-Merton (BSM) model
Black and Scholes (1973) and Merton (1973) derive option prices under the
following assumption on the stock price dynamics,

dSt = µSt dt + σSt dWt

The binomial model: Discrete states and discrete time (The number of
possible stock prices and time steps are both finite).
The BSM model: Continuous states (stock price can be anything between 0
and ∞) and continuous time (time goes continuously).
Scholes and Merton won Nobel price. Black passed away.
BSM proposed the model for stock option pricing. Later, the model has
been extended/twisted to price currency options (Garman&Kohlhagen) and
options on futures (Black).
I treat all these variations as the same concept and call them
indiscriminately the BMS model.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 3 / 36

Primer on continuous time process
dSt = µSt dt + σSt dWt

The driver of the process is Wt , a Brownian motion, or a Wiener process.

I The sample paths of a Brownian motion are continuous over time, but
nowhere differentiable.
I It is the idealization of the trajectory of a single particle being
constantly bombarded by an infinite number of infinitessimally small
random forces.
I If you sum the absolute values of price changes over a day (or any time
horizon) implied by the model, you get an infinite number.
I If you tried to accurately draw a Brownian motion sample path, your
pen would run out of ink before one second had elapsed.
The first who brought Brownian motion to finance is Bachelier in his 1900
PhD thesis: The theory of speculation.

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Properties of a Brownian motion
dSt = µSt dt + σSt dWt
The process Wt generates a random variable that is normally
distributed with mean 0 and variance t, φ(0, t). (Also referred to as Gaussian.)
Everybody believes in the normal approximation, the
experimenters because they believe it is a mathematical theorem,
the mathematicians because they believe it is an experimental
fact!

The process is made of independent normal increments dWt ∼ φ(0, dt).

I “d” is the continuous time limit of the discrete time difference (∆).
I ∆t denotes a finite time step (say, 3 months), dt denotes an extremely

thin slice of time (smaller than 1 milisecond).

I It is so thin that it is often referred to as instantaneous.
I Similarly, dW = W
t t+dt − Wt denotes the instantaneous increment
(change) of a Brownian motion.
By extension, increments over non-overlapping time periods are
independent: For (t1 > t2 > t3 ), (Wt3 − Wt2 ) ∼ φ(0, t3 − t2 ) is independent
of (Wt2 − Wt1 ) ∼ φ(0, t2 − t1 ).
Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 5 / 36
Properties of a normally distributed random variable

dSt = µSt dt + σSt dWt

If X ∼ φ(0, 1), then a + bX ∼ φ(a, b 2 ).

If y ∼ φ(m, V ), then a + by ∼ φ(a + bm, b 2 V ).
Since dWt ∼ φ(0, dt), the instantaneous price change
dSt = µSt dt + σSt dWt ∼ φ(µSt dt, σ 2 St2 dt).
dS
The instantaneous return S = µdt + σdWt ∼ φ(µdt, σ 2 dt).
I Under the BSM model, µ is the annualized mean of the instantaneous
return — instantaneous mean return.
I σ 2 is the annualized variance of the instantaneous return —
instantaneous return variance.
I σ is the annualized standard deviation of the instantaneous return —
instantaneous return volatility.

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Geometric Brownian motion
dSt /St = µdt + σdWt

The stock price is said to follow a geometric Brownian motion.

µ is often referred to as the drift, and σ the diffusion of the process.
Instantaneously, the stock price change is normally distributed,
φ(µSt dt, σ 2 St2 dt).
Over longer horizons, the price change is lognormally distributed.
The log return (continuous compounded return) is normally distributed over
all horizons:
d ln St = µ − 21 σ 2 dt + σdWt . (By Ito’s lemma)

I d ln St ∼ φ(µdt − 12 σ 2 dt, σ 2 dt).

I ln St ∼ φ(ln S0 + µt − 21
σ 2 t, σ 2 t).
ln ST /St ∼ φ µ − 21 σ 2 (T − t), σ 2 (T − t) .


I

1 2
Integral form: St = S0 e µt− 2 σ t+σWt
, ln St = ln S0 + µt − 21 σ 2 t + σWt

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Normal versus lognormal distribution
dSt = µSt dt + σSt dWt , µ = 10%, σ = 20%, S0 = 100, t = 1.
2 0.02

1.8 0.018

1.6 0.016 S0=100

1.4 0.014
PDF of ln(St/S0)

1.2 0.012

PDF of St
1 0.01

0.8 0.008

0.6 0.006

0.4 0.004

0.2 0.002

0 0
−1 −0.5 0 0.5 1 50 100 150 200 250
ln(St/S0) St

The earliest application of Brownian motion to finance is Louis Bachelier in his

dissertation (1900) “Theory of Speculation.” He specified the stock price as
following a Brownian motion with drift:

dSt = µdt + σdWt

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 8 / 36

Simulate 100 stock price sample paths
dSt = µSt dt + σSt dWt , µ = 10%, σ = 20%, S0 = 100, t = 1.
0.05 200

0.04
180
0.03
160
0.02
Daily returns

Stock price
0.01 140

0 120

−0.01
100
−0.02
80
−0.03

−0.04 60
0 50 100 150 200 250 300 0 50 100 150 200 250 300
Days days

Stock with the return process: d ln St = (µ − 12 σ 2 )dt + σdWt .

Discretize to daily intervals dt ≈ ∆t = 1/252.
Draw standard normal random variables ε(100 × 252) ∼ φ(0, 1).
√
Convert them into daily log returns: Rd = (µ − 12 σ 2 )∆t + σ ∆tε.
P252
Rd
Convert returns into stock price sample paths: St = S0 e d=1 .

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 9 / 36

The key idea behind BMS option pricing

Under the binomial model, if we cut time step ∆t small enough, the
binomial tree converges to the distribution behavior of the geometric
Brownian motion.
Reversely, the Brownian motion dynamics implies that if we slice the time
thin enough (dt), it behaves like a binomial tree.
I Under this thin slice of time interval, we can combine the option with
the stock to form a riskfree portfolio, like in the binomial case.
I Recall our hedging argument: Choose ∆ such that f − ∆S is riskfree.
I The portfolio is riskless (under this thin slice of time interval) and must
earn the riskfree rate.
I Since we can hedge perfectly, we do not need to worry about risk
premium and expected return. Thus, µ does not matter for this
portfolio and hence does not matter for the option valuation.
I Only σ matters, as it controls the width of the binomial branching.

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The hedging proof*
The stock price dynamics: dS = µSdt + σSdWt .
Let f (S, t) denote the value of
a derivative on the stock, by Ito’s lemma:
dft = ft + fS µS + 12 fSS σ 2 S 2 dt + fS σSdWt .
At time t, form a portfolio that contains 1 derivative contract and −∆ = fS
of the stock. The value of the portfolio is P = f − fS S.
The instantaneous uncertainty of the portfolio is fS σSdWt − fS σSdWt = 0.
Hence, instantaneously the delta-hedged portfolio is riskfree.
Thus, the portfolio must earn the riskfree rate: dP = rPdt.
dP = df − fS dS = ft + fS µS + 12 fSS σ 2 S 2 − fS µS dt = r (f − fS S)dt

This lead to the fundamental partial differential equation (PDE):

ft + rSfS + 12 fSS σ 2 S 2 = rf .
If the stock pays a continuous dividend yield q, the portfolio P&L needs to
be modified as dP = df − fS (dS + qSdt), where the stock investment P&L
includes both the capital gain (dS) and the dividend yield (qSdt).
The PDE then becomes: ft + (r − q)SfS + 21 fSS σ 2 S 2 = rf .
No where do we see the drift (expected return) of the price dynamics (µ) in
the PDE.
Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 11 / 36
Partial differential equation
The hedging argument leads to the following partial differential equation:

∂f ∂f 1 ∂2f
+ (r − q)S + σ 2 S 2 2 = rf
∂t ∂S 2 ∂S
I The only free parameter is σ (as in the binomial model).
Solving this PDE, subject to the terminal payoff condition of the derivative
(e.g., fT = (ST − K )+ for a European call option), BMS derive analytical
formulas for call and put option value.
I Similar formula had been derived before based on distributional
(normal return) argument, but µ was still in.
I More importantly, the derivation of the PDE provides a way to hedge
the option position.
The PDE is generic for any derivative securities, as long as S follows
geometric Brownian motion.
I Given boundary conditions, derivative values can be solved numerically
from the PDE.
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How effective is the BMS delta hedge in practice?
If you sell an option, the BMS model says that you can completely remove
the risk of the call by continuously rebalancing your stock holding to
neutralize the delta of the option.
We perform the following experiment using history S&P options data from
1996 - 2011:
I Sell a call option
I Record the P&L from three strategies
H Hold: Just hold the option.
S Static: Perform delta hedge at the very beginning, but with no further
rebalancing.
D Dynamic: Actively rebalance delta at the end of each day.
“D” represents a daily discretization of the BMS suggestion.
Compared to “H” (no hedge), how much do you think the daily discretized
BMS suggestion (“D”) can reduce the risk of the call?

[A] 0, [B] 5%, [C ] 50%, [D] 95%

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 13 / 36

Example: Selling a 30-day at-the-money call option
1.4 100
Hold
Static 95
1.2 Dynamics

Percentage Variance Reduction

90
Mean Squared Hedging Error

1 85

80
0.8
75
0.6
70

0.4 65

60
0.2
55 Static
Dynamic
0 50
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Days Days

Unhedged, the PL variance can be over 100% of the option value.

Un-rebalanced, the delta hedge deteriorates over time as the delta is no
longer neutral after a whole.
Rebalanced daily, 95% of the risk can be removed over the whole sample
period.
The answer is “D.”
Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 14 / 36
Hedging options at different maturities and time periods
Different maturities Different years
100 100

95 95
Percentage Variance Reduction

Percentage Variance Reduction

90 90

85 85

80 80

75 75

70 70

65 65

60 1 month 60 1 month
2 month 2 month
55 5 month 55 5 month
12 month 12 month
50 50
0 5 10 15 20 25 30 1996 1998 2000 2002 2004 2006 2008 2010
Days Year

Dynamic delta hedge works equally well on both short and long-term options.
Hedging performance deteriorates in the presence of large moves.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 15 / 36

The BSM formulae

ct = St e −q(T −t) N(d1 ) − Ke −r (T −t) N(d2 ),

pt = −St e −q(T −t) N(−d1 ) + Ke −r (T −t) N(−d2 ),
where
ln(St /K )+(r −q)(T −t)+ 21 σ 2 (T −t)
d1 = √
σ T −t
,
ln(St /K )+(r −q)(T −t)− 12 σ 2 (T −t) √
d2 = √
σ T −t
= d1 − σ T − t.
Black derived a variant of the formula for futures (which I like better):

ct = e −r (T −t) [Ft N(d1 ) − KN(d2 )],

ln(Ft /K )± 12 σ 2 (T −t)
with d1,2 = √
σ T −t
.

Recall: Ft = St e (r −q)(T −t) .

Once I know call value, I can obtain put value via put-call parity:
ct − pt = e −r (T −t) [Ft − Kt ].

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Cumulative normal distribution

ln(Ft /K ) ± 21 σ 2 (T − t)
ct = e −r (T −t) [Ft N(d1 ) − KN(d2 )] , d1,2 = √
σ T −t
N(x) denotes the cumulative normal distribution, which measures the
probability that a normally distributed variable with a mean of zero and a
standard deviation of 1 (φ(0, 1)) is less than x.
See tables at the end of the book for its values.
Most software packages (including excel) has efficient ways to computing
this function.
Properties of the BSM formula:
I As St becomes very large or K becomes very small, ln(Ft /K ) ↑ ∞,
N(d1 ) = N(d2 ) = 1. ct = e −r (T −t) [Ft − K ] .
I Similarly, as St becomes very small or K becomes very large,
ln(Ft /K ) ↑ −∞, N(−d1 ) = N(−d2 ) = 1. pt = e −r (T −t) [−Ft + K ].

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Implied volatility

ln(Ft /K ) ± 21 σ 2 (T − t)
ct = e −r (T −t) [Ft N(d1 ) − KN(d2 )] , d1,2 = √
σ T −t
Since Ft (or St ) is observable from the underlying stock or futures market,
(K , t, T ) are specified in the contract. The only unknown (and hence free)
parameter is σ.
We can estimate σ from time series return. (standard deviation calculation).
Alternatively, we can choose σ to match the observed option price —
implied volatility (IV).
There is a one-to-one correspondence between prices and implied volatilities.
Traders and brokers often quote implied volatilities rather than dollar prices.
The BSM model says that IV = σ. In reality, the implied volatility calculated
from different options (across strikes, maturities, dates) are usually different.

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Risk-neutral valuation

Recall: Under the binomial model, we derive a set of risk-neutral

probabilities such that we can calculate the expected payoff from the option
and discount them using the riskfree rate.
I Risk premiums are hidden in the risk-neutral probabilities.
I If in the real world, people are indeed risk-neutral, the risk-neutral
probabilities are the same as the real-world probabilities. Otherwise,
they are different.
Under the BSM model, we can also assume that there exists such an
artificial risk-neutral world, in which the expected returns on all assets earn
risk-free rate.
The stock price dynamics under the risk-neutral world becomes,
dSt /St = (r − q)dt + σdWt .
Simply replace the actual expected return (µ) with the return from a
risk-neutral world (r − q) [ex-dividend return].

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The risk-neutral return on spots

dSt /St = (r − q)dt + σdWt , under risk-neutral probabilities.

In the risk-neutral world, investing in all securities make the riskfree rate as
the total return.
If a stock pays a dividend yield of q, then the risk-neutral expected return
from stock price appreciation is (r − q), such as the total expected return is:
dividend yield+ price appreciation =r .
Investing in a currency earns the foreign interest rate rf similar to dividend
yield. Hence, the risk-neutral expected currency appreciation is (r − rf ) so
that the total expected return is still r .
Regard q as rf and value options as if they are the same.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 20 / 36

The risk-neutral return on forwards/futures

If we sign a forward contract, we do not pay anything upfront and we do not

receive anything in the middle (no dividends or foreign interest rates). Any
P&L at expiry is excess return.
Under the risk-neutral world, we do not make any excess return. Hence, the
forward price dynamics has zero mean (driftless) under the risk-neutral
probabilities: dFt /Ft = σdWt .
The carrying costs are all hidden under the forward price, making the pricing
equations simpler.

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Readings behind the technical jargons: P v. Q
P: Actual probabilities that cashflows will be high or low, estimated based
on historical data and other insights about the company.
I Valuation is all about getting the forecasts right and assigning the
appropriate price for the forecasted risk — fair wrt future cashflows and
your risk preference.
Q: “Risk-neutral” probabilities that we can use to aggregate expected future
payoffs and discount them back with riskfree rate, regardless of how risky
the cash flow is.
I It is related to real-time scenarios, but it has nothing to do with
real-time probability.
I Since the intention is to hedge away risk under all scenarios and
discount back with riskfree rate, we do not really care about the actual
probability of each scenario happening.
We just care about what all the possible scenarios are and whether our
hedging works under all scenarios.
I Q is not about getting close to the actual probability, but about being
fair wrt the prices of securities that you use for hedging.
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The BSM Delta
The BSM delta of European options (Can you derive them?):
∂ct ∂pt
∆c ≡ = e −qτ N(d1 ), ∆p ≡ = −e −qτ N(−d1 )
∂St ∂St
(St = 100, T − t = 1, σ = 20%)
BSM delta Industry delta quotes
1 100
call delta call delta
0.8 put delta 90 put delta

0.6 80

0.4 70

0.2 60
Delta

Delta
0 50

−0.2 40

−0.4 30

−0.6 20

−0.8 10

−1 0
60 80 100 120 140 160 180 60 80 100 120 140 160 180
Strike Strike

Industry quotes the delta in absolute percentage terms (right panel).

Which of the following is out-of-the-money? (i) 25-delta call, (ii) 25-delta
put, (iii) 75-delta call, (iv) 75-delta put.
The strike of a 25-delta call is close to the strike of: (i) 25-delta put, (ii)
50-delta put, (iii) 75-delta put.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 23 / 36

Delta as a moneyness measure
Different ways of measuring moneyness:
K (relative to S or F ): Raw measure, not comparable across different stocks.
K /F : better scaling than K − F .
ln K /F : more symmetric under BSM.
ln K /F
√ : standardized by volatility and option maturity, comparable across
σ (T −t)
stocks. Need to decide what σ to use (ATMV, IV, 1).
d1 : a standardized variable.
d2 : Under BSM, this variable is the truly standardized normal variable with
φ(0, 1) under the risk-neutral measure.
delta: Used frequently in the industry, quoted in absolute percentages.
I Measures moneyness: Approximately the percentage chance the option
will be in the money at expiry.
I Reveals your underlying exposure (how many shares needed to achieve
delta-neutral).

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Delta hedging

Example: A bank has sold for $300,000 a European call option on 100,000
shares of a nondividend paying stock, with the following information:
St = 49, K = 50, r = 5%, σ = 20%, (T − t) = 20weeks, µ = 13%.
I What’s the BSM value for the option? → $2.4
I What’s the BSM delta for the option? → 0.5216.
Strategies:
I Naked position: Take no position in the underlying.
I Covered position: Buy 100,000 shares of the underlying.
I Stop-loss strategy: Buy 100,000 shares as soon as price reaches $50,
sell 100,000 shares as soon as price falls below $50.
I Delta hedging: Buy 52,000 share of the underlying stock now. Adjust
the shares over time to maintain a delta-neutral portfolio.
F Need frequent rebalancing (daily) to maintain delta neutral.
F Involves a “buy high and sell low” trading rule.

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Delta hedging with futures

The delta of a futures contract is e (r −q)(T −t) .

The delta of the option with respect to (wrt) futures is the delta of the
option over the delta of the futures.
The delta of the option wrt futures (of the same maturity) is
∂ct ∂ct /∂St
∆c/F ≡ ∂Ft,T = ∂Ft,T /∂St = e −r τ N(d1 ),
∂pt ∂pt /∂St
∆p/F ≡ ∂Ft,T = ∂Ft,T /∂St = −e −r τ N(−d1 ).

Whenever available (such as on indexes, commodities), using futures to

delta hedge can potentially reduce transaction costs.

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OTC quoting and trading conventions for currency options

Options are quoted at fixed time-to-maturity (not fixed expiry date).

Options at each maturity are not quoted in invoice prices (dollars), but in
the following format:
I Delta-neutral straddle implied volatility (ATMV):
A straddle is a portfolio of a call & a put at the same strike. The strike
here is set to make the portfolio delta-neutral ⇒ d1 = 0.
I 25-delta risk reversal: RR25 = IV (∆c = 25) − IV (∆p = 25).
I 25-delta butterfly spreads:
BF25 = (IV (∆c = 25) + IV (∆p = 25))/2 − ATMV .
I Risk reversals and butterfly spreads at other deltas, e.g., 10-delta.
When trading, invoice prices and strikes are calculated based on the BSM
formula.
The two parties exchange both the option and the underlying delta.
I The trades are delta-neutral.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 27 / 36

The BSM vega
Vega (ν) is the rate of change of the value of a derivatives portfolio with
respect to volatility — it is a measure of the volatility exposure.
BSM vega: the same for call and put options of the same maturity
∂ct ∂pt √
ν≡ = = St e −q(T −t) T − tn(d1 )
∂σ ∂σ
x 2
n(d1 ) is the standard normal probability density: n(x) = √1 e − 2 .
2π

40
(St = 100, T − t = 1, σ = 20%) 40

35 35

30 30

25 25
Vega
Vega

20 20

15 15

10 10

5 5

0 0
60 80 100 120 140 160 180 −3 −2 −1 0 1 2 3
Strike d2

Volatility exposure (vega) is higher for at-the-money options.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 28 / 36

Vega hedging

Delta can be changed by taking a position in the underlying.

To adjust the volatility exposure (vega), it is necessary to take a position in
an option or other derivatives.
Hedging in practice:
I Traders usually ensure that their portfolios are delta-neutral at least
once a day.
I Whenever the opportunity arises, they improve/manage their vega
exposure — options trading is more expensive.
I As portfolio becomes larger, hedging becomes less expensive.
Under the assumption of BSM, vega hedging is not necessary: σ does not
change. But in reality, it does.
I Vega hedge is outside the BSM model.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 29 / 36

Example: Delta and vega hedging

Consider an option portfolio that is delta-neutral but with a vega of −8, 000. We
plan to make the portfolio both delta and vega neutral using two instruments:
The underlying stock
A traded option with delta 0.6 and vega 2.0.
How many shares of the underlying stock and the traded option contracts do we
need?

To achieve vega neutral, we need long 8000/2=4,000 contracts of the

traded option.
With the traded option added to the portfolio, the delta of the portfolio
increases from 0 to 0.6 × 4, 000 = 2, 400.
We hence also need to short 2,400 shares of the underlying stock ⇒ each
share of the stock has a delta of one.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 30 / 36

Another example: Delta and vega hedging
Consider an option portfolio with a delta of 2,000 and vega of 60,000. We plan to
make the portfolio both delta and vega neutral using:
The underlying stock
A traded option with delta 0.5 and vega 10.
How many shares of the underlying stock and the traded option contracts do we
need?

As before, it is easier to take care of the vega first and then worry about the
delta using stocks.
To achieve vega neutral, we need short/write 60000/10 = 6000 contracts of
the traded option.
With the traded option position added to the portfolio, the delta of the
portfolio becomes 2000 − 0.5 × 6000 = −1000.
We hence also need to long 1000 shares of the underlying stock.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 31 / 36

A more formal setup*
Let (∆p , ∆1 , ∆2 ) denote the delta of the existing portfolio and the two hedging
instruments. Let(νp , ν1 , ν2 ) denote their vega. Let (n1 , n2 ) denote the shares of
the two instruments needed to achieve the target delta and vega exposure
(∆T , νT ). We have
∆T = ∆p + n1 ∆1 + n2 ∆2
νT = νp + n1 ν1 + n2 ν2
We can solve the two unknowns (n1 , n2 ) from the two equations.
Example 1: The stock has delta of 1 and zero vega.
0 = 0 + n1 0.6 + n2
0 = −8000 + n1 2 + 0
n1 = 4000, n2 = −0.6 × 4000 = −2400.
Example 2: The stock has delta of 1 and zero vega.
0 = 2000 + n1 0.5 + n2
0 = 60000 + n1 10 + 0
n1 = −6000, n2 = 1000.
When do you want to have non-zero target exposures?
Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 32 / 36
BSM gamma
Gamma (Γ) is the rate of change of delta (∆) with respect to the price of
the underlying asset.
The BSM gamma is the same for calls and puts:

∂ 2 ct ∂∆t e −q(T −t) n(d1 )

Γ≡ 2 = = √
∂St ∂St St σ T − t

0.02
(St = 100, T − t = 1, σ = 20%) 0.02

0.018 0.018

0.016 0.016

0.014 0.014

0.012 0.012

Vega
Vega

0.01 0.01

0.008 0.008

0.006 0.006

0.004 0.004

0.002 0.002

0 0
60 80 100 120 140 160 180 −3 −2 −1 0 1 2 3
Strike d2

Gamma is high for near-the-money options.

High gamma implies high variation in delta, and hence more frequent rebalancing
to maintain low delta exposure.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 33 / 36

Gamma hedging
High gamma implies high variation in delta, and hence more frequent
rebalancing to maintain low delta exposure.
Delta hedging is based on small moves during a very short time period.
I assuming that the relation between option and the stock is linear
locally.
When gamma is high,
I The relation is more curved (convex) than linear,
I The P&L (hedging error) is more likely to be large in the presence of
large moves.
The gamma of a stock is zero.
We can use traded options to adjust the gamma of a portfolio, similar to
what we have done to vega.
But if we are really concerned about large moves, we may want to try
something else.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 34 / 36

Static hedging
Dynamic hedging can generate large hedging errors when the underlying
variable (stock price) can jump randomly.
I A large move size per se is not an issue, as long as we know how much

it moves — a binomial tree can be very large moves, but delta hedge
works perfectly.
I As long as we know the magnitude, hedging is relatively easy.
I The key problem comes from large moves of random size.
An alternative is to devise static hedging strategies: The position of the
hedging instruments does not vary over time.
I Conceptually not as easy. Different derivative products ask for different

static strategies.
I It involves more option positions. Cost per transaction is high.
I Monitoring cost is low. Fewer transactions.
Examples:
I “Static hedging of standard options,” Carr and Wu, JFEC.

I “Simple Robust Hedging With Nearby Contracts,” Wu and Zhu,

working paper.
Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 35 / 36
Summary

Understand the basic properties of normally distributed random variables.

Map a stochastic process to a random variable.
Understand the link between BSM and the binomial model.
Memorize the BSM formula (any version).
Understand forward pricing and link option pricing to forward pricing.
Understand the risk exposures measured by delta, vega, and gamma.
Form portfolios to neutralize delta and vega risk.

Liuren Wu ( Baruch) The Black-Merton-Scholes Model Options Markets 36 / 36