Financial Engineering & Risk Management

MFIM 7111

Tamirat T.(PhD)
May 5, 2025
Addis Ababa University
School of Comerce

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Table of Contents

The Greek Letters

Greeks Letter Calculation
Dynamical Delta Hedging

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The Greek Letters
The Greek Letters

Example

• A financial institution (bank) has sold for $300, 000 a

European call option on 100, 000 shares of a non-dividend
paying stock
• S0 = 49, K = 50, r = 5%, σ = 20%, T = 20 weeks, µ = 13%
• The Black-Scholes-Merton value of the option is $240, 000
(This is because the value of an option to buy one share is
$2.4)
• How does the bank hedge its risk to lock in a $60, 000 profit?

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Naked & Covered Positions

• Naked position
✓ Take no action
• Covered position
✓ Buy 100, 000 shares today
• What are the risks associated with these strategies?

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The Greek Letters

• In the case of a naked position, if the stock price drops below

the strike price after 20 weeks, the strategy works well.
• However, if the stock price moves up, the call will be
exercised, incurring costs for the bank.
• The institution will have to purchase 100,000 shares at the
market price to cover the call.

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The Greek Letters

• For example, if after 20 weeks the stock price is $60, the

option will cost the institution $1,000,000.
• This will result in a loss for the institution, calculated as
$300,000 - $1,000,000, which equals -$700,000.

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The Greek Letters

• In the case of a covered position, if the stock price goes above

the strike price, the call will be exercised.
• Since the institution has already purchased the shares, there
will be no problem covering the call.
• In this scenario, the institution will gain the premium charged
for the option, which is $300,000.

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• However, if the stock price drops to $40, the bank will incur a
loss of $900,000 on its stock position. This loss is significantly
greater than the $300,000 charged for the option.
• Neither a naked position nor a covered position provides a
good hedge.

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 The Greek Letters

Stop-Loss Strategy

• This involves:
✓ Buying 100, 000 shares as soon as prices reaches $50
✓ Selling 100, 000 shares as soon as prices falls below $50

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 The Greek Letters

Stop-Loss Strategy ... Cont’d

50.2

50.0

49.8

49.6

49.4

49.2

49.0

48.8 Stock price, S(t)

Strike priec K = 50
48.6
0.0 0.2 0.4 0.6 0.8 1.0
t

Figure 1: A stop-loss strategy

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 The Greek Letters
Greeks Letter Calculation

Greeks

• Greek letters are the partial derivatives with respect to the

model parameters that are liable to change
• Usually traders use the Black-Scholes-Merton model when
calculating partial derivatives.
• The volatility parameter in BSM is set equal to the implied
volatility when Greek letters are calculated. This is referred to
as using the “practitioner Black-Scholes” model

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 The Greek Letters
Greeks Letter Calculation

Delta

• Delta (∆) is the rate of change of the option price with

respect to the underlying asset price.
∂c
∆=
∂S
A graphical demonstration for Delta as a slop
Slope = Δ = 0.6
Tangent Point
Option price

Stock price
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The Greek Letters
Greeks Letter Calculation

Example 1
Suppose the delta of a call option on stock is 0.6, (see Figure (2)).
When the stock price changes by small amount, the option price
changes by about 60% of the amount. Suppose that the stock
price is 70 and the option price is 8. Imagine an investor who has
sold call option to buy 2, 000 shares on a stock. The investor’s
position could be hedged by buying

0.6 × 2, 000 = 1, 200 shares.

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The Greek Letters
Greeks Letter Calculation

• Gain/loss on the option position is offset by loss/gain on

stock position.
• For instance, if the stock price goes up by $1, i.e., ∆S = 1
producing a gain on the shares purchased, the option price
will tend to go up by,

∆ × ∆S = 0.6 × 1 = $0.6,

(producing a loss of $1, 200 on the options written);

• if the stock price goes down by $1 (producing a loss of $1, 200
on the shares purchased), the options will tend to go down by
$0.60(producing a gain of $1, 200 on the options written).

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The Greek Letters
Greeks Letter Calculation

Scenario (∆S) (∆c) Gain/Loss Gain/Loss

on Option on Stock
Stock Up (1) +1 +0.60 -1, 200 +1, 200
Stock Down (1) -1 -0.60 +1, 200 -1, 200
Table 1: Table demonstrating that gain/loss on option is offset by
loss/gain on stock. Initially: stock price $70, option price $8, the delta of
the call option is 0.6.

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The Greek Letters
Greeks Letter Calculation

• The delta of the trader’s overall position in our example is

zero (15). A position with a delta of zero is referred to as
delta neutral.
• Delta changes as stock price changes and time passes
• Hedge position must therefore be rebalanced

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 The Greek Letters
Greeks Letter Calculation

Delta hedging

• This involves maintaining a delta neutral portfolio

• The delta of a European call on a non-dividend paying stock
is N (d1 )
• The delta of a European put on the stock is

N (d1 ) − 1

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The Greek Letters
Greeks Letter Calculation

Theta

• Theta (Θ) of a derivative (or portfolio of derivatives) is the

rate of change of the value with respect to the passage of time
• The theta of a call or put is usually negative. This means
that, if time passes with the price of the underlying asset and
its volatility remaining the same, the value of a long call or
put option declines

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The Greek Letters
Greeks Letter Calculation

S0 N ′ (d1 )σ
Θ(call) = − √ − rKe−rT N (d2 )
2 T
here
1 2
N ′ (x) = √ e−x /2
2π
is the probability density function for a standard normal
distribution.

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The Greek Letters
Greeks Letter Calculation

For a European put option on the stock,

S0 N ′ (d1 )σ
Θ(put) = − √ + rKe−rT N (−d2 )
2 T

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The Greek Letters
Greeks Letter Calculation

Gamma

• Gamma (Γ) is the rate of change of delta (∆) with respect to

the price of the underlying asset

∂2Π
Γ=
∂S 2
• Gamma is greatest for options that are close to the money

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 The Greek Letters
Greeks Letter Calculation

Interpretation of Gamma

For a delta neutral portfolio, ∆Π ≈ Θ∆t + 12 Γ∆S 2

slightly positive gamma large positive gamma

3 3

2 2

1 1

0 0
ΔΠ

ΔΠ
−1 −1

−2 −2

−3 −3
ΔS ΔS
slightly negative gamma large negative gamma
3 3

2 2

1 1

0 0
ΔΠ

ΔΠ

−1 −1

−2 −2

−3 −3

−4 −3 −2 −1 0 1 2 3 4 −4 −3 −2 −1 0 1 2 3 4
ΔS ΔS

Figure 3: Relationship between ∆Π and ∆S in time ∆t for a delta 22

 The Greek Letters
Greeks Letter Calculation

Relationship Between Delta, Gamma, and Theta

For a portfolio of derivatives on a stock paying a continuous

dividend yield at rate q it follows from the Black-Scholes-Merton
differential equation that
1
Θ + rS∆ + σ 2 S 2 Γ = rΠ
2
For a delta-neutral portfolio, ∆ = 0
1
Θ + σ 2 S 2 Γ = rΠ
2

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The Greek Letters
Greeks Letter Calculation

Vega

• Vega (ν) is the rate of change of the value of a derivatives

portfolio with respect to volatility
• If vega is calculated for a portfolio as a weighted average of
the vegas for the individual transactions comprising the
portfolio, the result shows the effect of all implied volatilities
changing by the same small amount

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 The Greek Letters
Dynamical Delta Hedging

Dynamical Delta Hedging

• The sensitivity of an option to changes in the underlying asset

is represented by the delta, denoted as ∆.
• Careful selection of the delta value is crucial for effective risk
management. Delta can be used to construct a portfolio that
hedges against risk.
• A trader can neutralize the effect of stock price fluctuations
by offsetting the sale of options with a simultaneous purchase
of the stock itself.
• Recall that the delta for call and put are given by,
∂C ∂P
= N (d1 ), and = N (d1 ) − 1,
∂S ∂S
respectively.
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 The Greek Letters
Dynamical Delta Hedging

Replicating portfolio

• Replication of a call option C(t) needs to find a self-financing

portfolio {(θ(t), ∆(t)), 0 ≤ t ≤ T } such that,

∆(t)S(t) + θ(t)B(t) = C(t), (1)

in all possible scenario, at any time 0 ≤ t ≤ T . In equation

(1), Bt represents the value of the risk-free (bond) asset at
time t.

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The Greek Letters
Dynamical Delta Hedging

• From the Black-Scholes formula we directly obtain,

∆(t) = N (d1 (t, S)) , (2)

−rT
θ(t) = −Ke N (d2 (t, S)) . (3)

• That means, at any time t, in order to replicate the value of

the call,
✓ we must be long N (d1 (t, S)) units of S and
✓ short Ke−rT N (d2 (t, S)) units of B(t).

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The Greek Letters
Dynamical Delta Hedging

Example 2
Assume a stock, currently trading for $100, behaves according to a
geometric Brownian motion with mean return of 6% and volatility
of 30%. If the risk-free rate is 3%, find the replicating strategy of a
1−year at-the-money call option:

• at inception;
• after 6 months, in the scenario where S(0.5) = 115;
• and just before maturity, in the scenario where S(1−) = 107.

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 The Greek Letters
Dynamical Delta Hedging

Steps for dynamic delta hedging for European call option

Step 1: Estimate the necessary parameter-volatility

Step 2: At t = t0 = 0, calculate the theoretical price C(t0 ).
✓ Compute the ∆(t0 ) = N (d1 (t0 , S0 )).
✓ Hence the initial portfolio value

Π0 = C(t0 ) = ∆(t0 )S0 + θ(t0 )B(t0 ). (4)

✓ Here we can see that θ(t0 ) = C(t0 )−∆(t

B(t0 )
0 )S0
.
✓ Therefore the initial portfolio can be written as:

Π0 = ∆(t0 )S0 + (C(t0 ) − ∆(t0 )S0 ). (5)

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The Greek Letters
Dynamical Delta Hedging

In other word, the portfolio should have ∆(t0 )S0 invested in the
stock and the remainder (C(t0 ) − ∆(t0 )S0 ) invested in the
risk-free asset. Note that we hold on to the quantities
(∆(t0 ), θ(t0 )) up to the next period t1 .

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 The Greek Letters
Dynamical Delta Hedging

Step 3: At t = t1 , S(t1 ) is realized form the market, we will choose

(∆(t1 ), θ(t1 )) such that

∆(t0 )S(t1 ) + θ(t0 )B(t1 ) = ∆(t1 )S(t1 ) + θ(t1 )B(t1 ) = Π(t1 ).

(6)
Now, ∆(t1 ) = N (d1 (S(t1 ), t1 )) and calculating for θ(t1 ) gives;

θ(t1 ) = e−rt1 {(∆(t0 )S(t1 ) + θ(t0 )ert1 ) − ∆(t1 )S(t1 )}. (7)

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 The Greek Letters
Dynamical Delta Hedging

Step 4: Repeat the similar procedure for i = 2, . . . , m − 1. At the

trading date ti ,

∆(ti−1 )S(ti )+θ(ti−1 )B(ti ) = ∆(ti )S(ti )+θ(ti )B(ti ) = Π(ti ).

(8)
Solving for θ(ti ),

θ(ti ) = e−rti {(∆(ti−1 )S(ti ) + θ(ti−1 )erti ) − ∆(ti )S(ti )}. (9)

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The Greek Letters
Dynamical Delta Hedging

P&L

• Suppose we sold a call C(t0 , S) at time t0 , with maturity T

and strike K. By selling, we obtained a cash amount equals
C(t0 , S) and perform a dynamic hedging strategy until time
T.
• Initially, at the inception time, we have

θ(t0 , S) := C(t0 , S) − ∆(t0 )S0 .

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The Greek Letters
Dynamical Delta Hedging

P&L

• This value may be negative when ∆(t0 )S0 > C(t0 , S).
• If funds are needed for buying ∆(t) shares, we make use of a
funding account, P nL(t) ≡ P &L(t).
• P nL(t) represents the total value of the option sold and the
hedge, and it keeps track of the change in the asset value
S(t).

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The Greek Letters
Dynamical Delta Hedging

• At t1 > t0 , we then receive (or pay) interest over the time

period [t0 , t1 ], which will amount to P &L(t0 )er(t1 −t0 )
• At t1 we have ∆(t0 )S(t1 ) which may be sold, and we will
update hedge portfolio. Particularly, we purchase ∆(t1 )
stocks, costing −∆(t1 )S(t1 ).
• The overall P &L(t1 ) account will become:

P &L(t1 ) = P &L(t0 )er(t1 −t0 ) −(∆(t1 ) − ∆(t0 ))S(t1 ) (10)

| {z }| {z }
interest borrow

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The Greek Letters
Dynamical Delta Hedging

T
• Assuming a time grid with ti = i m , the following recursive
formula for the m time steps is obtained.

P &L(t0 ) = C(t0 , S) − ∆(t0 )S(t0 )

P &L(ti ) = P &L(ti−1 )er(ti −ti−1 ) − (∆(ti ) − ∆(ti−1 ))S(ti ),

i = 1, . . . , m − 1.

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The Greek Letters
Dynamical Delta Hedging

• At the maturity time T , the option holder may exercise the

option or the option will expire worthless.
• As the option writer, we will thus encounter a cost equal to
the option’s payoff at tm = T , i.e. max(S(T ) − K, 0).
• On the other hand, at maturity time we own ∆(tm−1 ) stocks,
that may be sold in the market.

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The Greek Letters
Dynamical Delta Hedging

• The value of the portfolio at maturity time tm = T is then

given by:
r(tm −tm−1 )
P &L(tm ) = P &L(tm−1 )e − max(S(tm ) − K, 0) + ∆(tm−1 )S(tm ) . (11)
| {z } | {z }
option payoff sell stocks

• In a perfect world, with continuous re-balancing, the P &L(T )

would equal zero on average, i.e. E(P &L(T )) = 0.

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Dynamical Delta Hedging

Remark 1
One might question the rationale behind dynamic hedging when
the average profit for the option writer is zero. In option trading,
particularly with over-the-counter (OTC) transactions, the profit
arises from charging an additional fee, commonly known as a
"spread," at the contract’s initiation. At time t0 , the cost for the
client is not C(t0 , S) but C(t0 , S) + spread, where spread > 0
represents the profit for the option writer.

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The Greek Letters
Dynamical Delta Hedging

Example 3 (Dynamic hedge experiment, Black-Scholes

model)
Consider the following scenario: For the asset price, the following
model parameters are set S(t0 ) = 1, r = 0.1, σ = 0.2. The option’s
maturity is T = 1 and strike K = 0.85.

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The Greek Letters
Dynamical Delta Hedging

1.5

1.0

0.5
Price
0.0 Call
P\&L
−0.5 Delta

−1.0

−1.5

0 50 100 150 200 250

time (days)

Figure 4: Delta hedging a call option. Option ending ITM

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The Greek Letters
Dynamical Delta Hedging

1.0

0.5

0.0

−0.5
Price
−1.0 Call
P\&L
Delta
0 50 100 150 200 250
time (days)

Figure 5: Delta hedging a call option: Option ending OTM

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The Greek Letters
Dynamical Delta Hedging

1.0

0.5

0.0 Price
Call
P\&L
−0.5 Delta

−1.0

−1.5
0 50 100 150 200 250
time (days)

Figure 6: Delta hedging a call option. Option ending ATM

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The Greek Letters
Dynamical Delta Hedging

For further reading: (Hull, 2021, Chapter 15, 19)

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References
Hull, J. C. (2021). Options futures and other derivatives. Pearson
Education India.

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