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HW For M8 - Hedging With Options

The document contains 5 problems related to hedging options positions: [1] Explains how a position of 1000 options with a delta of 0.7 can be made delta neutral by purchasing 700 shares. [2] Calculates the delta of an at-the-money 6-month European call as 0.645 given a risk-free rate of 10% and volatility of 25%. [3] Defines gamma as the rate of change of delta with respect to price and explains the risks when gamma is large and negative and delta is zero. [4] Gives a portfolio and asks how to make it gamma/delta and vega/delta neutral by taking positions in an additional traded

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71 views3 pages

HW For M8 - Hedging With Options

The document contains 5 problems related to hedging options positions: [1] Explains how a position of 1000 options with a delta of 0.7 can be made delta neutral by purchasing 700 shares. [2] Calculates the delta of an at-the-money 6-month European call as 0.645 given a risk-free rate of 10% and volatility of 25%. [3] Defines gamma as the rate of change of delta with respect to price and explains the risks when gamma is large and negative and delta is zero. [4] Gives a portfolio and asks how to make it gamma/delta and vega/delta neutral by taking positions in an additional traded

Uploaded by

Niyati Shah
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© © All Rights Reserved
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HOMEWORK SET FOR MODULE 8

HEDGING WITH OPTIONS

Problem 1
What does it mean to assert that the delta of a call option is 0.7? How can a short
position in 1000 options be made delta neutral when the delta of each option is 0.7?

We can conclude that having delta of 0.7 while stock increases a little the price for option
will increase 70%. On the other hand when the price decreases so will the price option at
70%. For 1000 options it has delta of 700, can be made delta neutral with purchasing 700
shares.

Problem 2
Calculate the delta of an at-the-money six-month European call option on a non-
dividend-paying stock when the risk-free interest rate is 10% per annum and the stock
price volatility is 25% per annum.

Six month means time is 0.5 years risk-free rate is 10% price volatility is 25%.
S0
At the money means stock price = strike price. So ( ¿=1
K
2
S0 α
d1 =
ln
k( )(
+ r + ∗T
2 )
α∗√ T

25 % 2
= (
ln ( 1 )+ 10 % +
2 )
∗0.5

25 %∗√ 0.5

0.0625
= (
0+ 0.1+
2 )
∗0.5

0.25∗0.71

0.13∗0.5
=
0.18

0.066
= = 0.38
0.18

Value of Debt = N(d1)

= N(0.38)

= 0.645
Thus the value of delta N(d1) is 0.645.

Problem 3
What is meant by the gamma of an option position? What are the risks in the situation
where the gamma of a position is large and negative and the delta is zero?
Gamma of an option position is the rate of change in the position of delta with respect to the
asset price. When the gamma of an option of a position is large and negative and the delta is
zero the option will lose significant amounts of money if there is a large position change
(either an increase or a decrease) in the asset price. For example When gamma = 0. 5
means the asset price increases by a certain small amount
delta increases by 0.5 of this amount.

Problem 4
A financial institution has the following portfolio of over-the-counter options on Stock
of Sterling Company:

Type Position Delta of Option Gamma of Option Vega of Option


Call −1000 0.5 2.2 1.8
Call −500 0.8 0.6 0.2
Put −2000 -0.40 1.3 0.7
Call −500 0.70 1.8 1.4

Sterling Co. is currently trading at $50 per share.

A traded option on Sterling Co. is available with a delta of 0.6 a gamma of 1.5 and a
vega of 0.8.
The delta of the portfolio is
-1000 *0.5 – 500 *0.8 – 2000*(-0.4) – 500*0.7 = -450

The gamma of the portfolio is


-1000*2.2 – 500*0.6 – 2000*1.3 – 500*1.8 = -6000

The vega od the portfolio is


-1000*1.8 – 500*0.2 – 2000*0.7 – 500*1.4 = -4000

(a) What position in the traded option and in Sterling stocks would make the portfolio
both gamma neutral and delta neutral?
A long position in 4000 traded options will give a gamma-neutral portfolio since the long
position has a gamma of 4000*1.5 = 6000. The delta of the whole portfolio (include
traded option) is then:

4000*0.6 -450 = 1950


Hence in addition to the 4000 traded options a short position of 1950 is sterling is
necessary so that the portfolio is both gamma and delta neutral.
(b) What position in the traded option and in Sterling stocks would make the portfolio
both vega neutral and delta neutral?
A long position in 5000 traded options will give a vega-neutral portfolio since the long
position has a vega of 5000*0.8 = 4000. The delta of the whole portfolio (include traded
options) is then:

5000*0.6 – 450 = 2550

Hence in addition to the 5000 traded options a short position of 2550 in sterling is
necessary so that the portfolio is both vega and delta neutral.

Problem 5
Consider again the situation in Problem 4. Suppose that a second traded option with a
delta of 0.1 a gamma of 0.5 and a vega of 0.6 is available. How could the portfolio be
made delta gamma and vega neutral?

Let w1 be the position in the first traded option


w2 be the position in the second traded option.
6000=1.5w1 + 0.5w2
4000=0.8w1 + 0.6w2

w1=3200 w2 = 2400
-450 + 3200*0.6 +2400*0.1 = 1710

Therefore portfolio can be made delta gamma and vega neutral by taking a long position in
3200 of the first traded option a long position in 2400 of the second traded option and a short
position of 1710 in sterling.

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