Greeks and Volatility Smile

Financial Derivatives
Greeks and Volatility Smile
Dr Eirini Konstantinidi & Dr Ser-Huang Poon
(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 1 / 51

Summary
In the previous two lectures we discussed how to price calls & puts.
k Discrete & continuous time approaches.
In this lecture we will discuss how we can use these insights to hedge.
k Several partial derivatives are useful for hedging.
We will also look at discuss implied volatility.
Finally, we will discuss volatility smiles and discuss how they arise.

Outline
Video 1: Intended learning outcomes.
Video 1: Hedging - Setting the stage
Video 2: Greeks and hedging
Video 3: Implied volatility and the volatility smile.

Intended learning outcomes
By the end of this lecture you should be able to:
Understand what hedging and what a good hedge is in our setting.
Define greeks.
Perform hedging using greeks.
Understand, discuss and calculate implied volatility.
Discuss the volatility smile/skew.
Explain why we may be observing a volatility smile/skew.

Reading list
Hull (6th Edition): Chapter 15 & 16.
Hull (9th & 10th Edition): Chapter 19 & 20.

Hedging: Setting the stage

Setting the stage: An example
Consider a financial institution that has sold for $300,000 a European call
option on 100,000 shares on a non-dividend paying stock.
k Spot stock price (S0 ): 49, Strike (K ): 50, Interest rate(r ): 5%, Volatility (σ):
20
20%, Time-to-maturity (T ): 20 weeks (i.e. 52 = 0.3846 years).
What is the Black-Scholes call value?

1 Calculate d1 and d2 .
2 Look up N (d1 ) and N (d2 ) in normal distribution table.
3 Plug into the Black-Scholes formula.
Following these steps, the Black-Scholes call value is $240,000.

k The call was sold for $60,000 more than its theoretical value.
But the institution is faced with the problem of hedging the option risk!
k Alternative strategies: Naked position, covered position, stop-loss strategy.
Naked (or uncovered) position
Do nothing.
No problem if the stock price at maturity is low, i.e. below K = $50.

k In this case the European call will not be exercised.
k Profit of $300,000.
If the stock price at maturity is above K = $50 the call will be exercised.
k The financial institution needs to buy 100,000 shares at maturity.
Example: ST = 60.
k In this case the financial institution will suffer losses.
100, 000 · (−1) · max (ST − K , 0) = −100, 000 · max (60 − 50, 0) = −1M

Covered positions
Buy 100,000 shares immediately.
No problem if future stock price is high, i.e. above K = $50.

k In this case the European call will be exercised.
If the stock price at maturity is bellow K = $50 the call will not be
exercised.
Example: ST = 40.
k In this case the financial institution will suffer losses.
100, 000 · (ST − S0 ) = −900, 000.
The naked and the covered positions are both sub-optimal!

A more sophisticated strategy: The stop-loss trategy
The stop-loss strategy involves:

k Buying 100,000 stocks if St rises above K = $50.
k Selling 100,000 stocks if St falls below K = $50 .
This strategy ensures that the institution holds the stock, if the option
matures ITM & does not hold the stock if the option matures OTM.

The stop-loss strategy
Total costs of this strategy appear to be: Q = max(S0 − K , 0)

k We buy/sell the stock at a price K each time.
k In the absence of transaction costs, this strategy would work perfectly.
This reasoning is incorrect.

1 Intermediate gains and losses need to be discounted.
2 Buy (sell) at a price slightly larger (smaller) than K → costs are larger.
In practice, we buy (sell) the stocks at a price K + ε (K − ε).

k Every time we buy and subsequently sell the stock, we incur a cost of 2ε.
k By monitoring the stock price closely, ε can be made arbitrarily small.
k As ε → 0, the expected number of trades tends to infinity.
The stop-loss strategy does not work well in practice.

k If the stock prices crosses K many times, this strategy is expensive.
Greeks & Hedging

Introduction of the Greeks
Greeks: Sensitivity factors.

k Partial derivative of asset/portfolio price w.r.t. a variable that it depends on.
The following partial derivatives are useful for hedging purposes:
k Delta: ∆c = ∂c
∂S ∆p = ∂p
∂S
∂2 c ∂2 p
Γc = Γp =
∂∆c ∂∆p
k Gamma: ∂S 2
= ∂S ∂S 2
= ∂S
∂c ∂p
k Vega: νc = ∂σ νp = ∂σ
k Theta: Θc = ∂c
∂t Θp = ∂p
∂t
∂c ∂p
k Rho: ρc = ∂r ρp = ∂r

Delta (∆)
Delta, ∆, is the rate of change of the derivative price (call, c or put p

price), with respect to the price of the underlying asset, S.
Calls: ∆c = ∂∂Sc Puts: ∆p = ∂∂Sp
Delta is important for hedging purposes.

k Delta-neutral portfolios.

Variation of Delta w.r.t. to the stock price

Delta of calls and puts: Black-Scholes (-Merton) world
Delta is closely related to the Black-Scholes (-Merton) analysis.

k To derive the Black-Scholes (-Merton) p.d.e. we set up a riskless portfolio.
k Buy δ = ∂∂Sf units of the stock & sell one option → delta-neutral portfolio.
Consider a non-dividend paying stock whose price a GBM:

dS
dS = µSdt + σSdz ⇔ S
= µdt + σdz
This means that we are in a Black-Scholes world and hence, the pricess
of European options are given by the Black-Scholes formula.
In this case, the delta of European stock-options is:

Long call: ∆c = N (d1 ) Long put: ∆p = N (d1 ) − 1

Delta hedging
Delta hedging involves maintaining a delta-neutral portfolio.

k Delta of a hedged portfolio is equal to zero.
Let a portfolio Π consist of n assets whose price depends on a single

asset with a price S.
n
∂Π
∆Π = = ∑ wi ∆ i
∂S i =1
where wi is the quantity (not proportion) & ∆i is the delta of the i-th asset.
For delta hedging purposes (i.e. hedging with respect to changes in the
asset price) we want to set: ∆Π = 0
k We need to choose wi appropriately.

Delta hedging: Portfolio of one option and some stocks
Consider a portfolio consisting of one option and w stock stocks.

k What is the appropriate value of w so that the portfolios is delta-neutral?
The portfolio delta is: ∆Π = w option ∆option + w stock ∆stock
Note that:
1 We have one option in the portfolio, i.e. w option = 1 .
2 For the stock we have that: ∆stock = ∂∂SS = 1
3 We want to construct the delta-neutral portfolio, i.e. ∆Π = 0.
This means that:

0 = ∆option + w stock ⇔ w stock = −∆option
Hence, delta hedging involves selling ∆option stocks for each option held.
Delta Hedging: Some remarks
Delta is a dynamic measure and changes with S:

k Delta-neutrality is only maintained for a short time (instant).
k As a result, the hedge has to be adjusted periodically.
k This is known as portfolio re-balancing.
Delta hedging of a written option involves a ’buy high, sell low’ trading
strategy: very risky!

Delta hedging: An example I
An investor sells 20 calls on a non-dividend paying stock.

k Each call is written on 100 stocks.
k Call price c = $10.
k Call delta ∆call = 0.6 (for long position).
To delta-hedge this position we buy/sell w stock stocks:

w call ∆call + w stock ∆stock = 0
⇔ 20 · 100 · (−0.6) + w stock · 1 = 0

⇔ w stock = 1, 200
i.e. to delta-hedge we buy 1,200 stocks.
The gain (loss) from the option is equal to the loss(gain) from the stocks.

Delta hedging: An example II
A trader owns:
1 A long position in 100,000 calls with a Delta of 0.533.
2 A short position in 200,000 calls with a Delta of 0.468.
3 A short position in 50,000 puts with a Delta of -0.508.
The Delta of this portfolio is:

100, 000 · 0.533 − 200, 000 · 0.468 − 50, 000 · (−0.508) = −14, 900
To delta hedge we need to buy/sell w stock stocks.

100, 000 · 0.533 − 200, 000 · 0.468 − 50, 000 · (−0.508) + w stock · 1 = 0
⇔ w stock = 14, 900
i.e. the portfolio can be made delta-neutral by buying 14,900 shares.
Delta hedging is more ’feasible’ in the case of portfolio of options.

k Transaction costs.
Delta hedging: An example III
Consider our earlier example.
k A financial institution sold for $300,000 European call options on 100,000
shares on a non-dividend paying stock.
k S0 = 49, K = 50, r = 5%, σ = 20%, T = 20 (i.e. 0.3846 years).
Assume that stock prices follow a GBM.

k ∆
call
= N (d1 ) = 0.522
k Buy 0.522 stocks per option sold (i.e. 0.522 · 100, 000 = 52, 200 stocks).
k Total cost for buying the stocks: 52, 200 · 49 = 2, 557, 800.
k Weekly interest: 2, 557, 800 · (e0.05 − 1)/52 ≈ 2, 500.
After a week, the stock price drops to $48.12:

k Now ∆
call
= 0.458.
k The financial institution sells (0.522 − 0.458) · 100, 000 = 6400 stocks.
k The borrowing is reduced to $2,252,300 (≈ 2, 557, 800 + 2, 500 − 6400 · 48.12).
. . . and so on until maturity . . .

Delta hedging: An example III (cont’d)

Gamma (Γ)
Gamma, Γ, is the rate of change of Delta, ∆, with respect to the price of

the underlying asset, S.
2 2
Calls: Γc = ∂∂Sc2 = ∂∆ Puts: Γp = ∂∂Sp2 = ∂Sp
c ∂∆
∂S
Delta changes as S changes → rebalancing is needed to delta hedge.

k Gamma is rate of change of delta as S changes.
Large Gamma → Delta is sensitive to price changes,

i.e. frequent re-balancing of the portfolio is necessary.
Small Gamma → Delta is not very sensitive to price changes,

i.e. infrequent re-balancing of the portfolio is necessary.

Variation of Gamma w.r.t. the stock price
Gamma is maximised near-the-money.
Gamma takes the lowest value as we away from the money.

Delta hedging error
Stock price changes from S to S 0 .

Delta hedging assumes that the option price changes from C to C 0 .
However, in reality the option price moves from C to C 00 .
k Hedging error HE = C 00 − C 0 .
k HE depends on the curvature of the relationship between option & stock price.
k The curvature is measured by gamma.

An example: The Black-Scholes model
N 0 ( d1 )
Assume call option value follows Black-Scholes model: Γ = √ .
Sσ T − t
Consider the following parameters:

k S0 = 42, K = 40, σ = 0.30, r = 0.04, T = 1 year.
From the Black-Scholes model we have that:

c = 6.786 ∆ = 0.672 Γ = 0.029
Delta-neutral portfolio: Buy one option & sell 0.672 stocks.

An example: The Black-Scholes model (cont’d)
Stock price increases by 0.1.

k The call price now c = 6.853, i.e. higher by 0.067.
k The short stock position is worth less 0.672 · 0.1 = 0.0672.
⇒ Good hedge.
Stock price increases by 10.

k The call price now c = 14.661, i.e. higher by 7.875.
k The short stock position is worth less 0.672 · 10 = 6.72.
⇒ Bad hedge.
The problem is that the position is not Gamma-neutral.

Making a portfolio Gamma-neutral

n
ΓΠ = ∑ wi Γi
i =1
Hedging Gamma risk → ΓΠ = 0.
Underlying asset (e.g., the stock) has a Gamma of zero.

k It cannot be used to hedge Gamma risk.
To hedge gamma risk, we need to take a position in a derivative.

Making a portfolio Gamma-neutral (Cont’d)
Assume that you hold a portfolio that has a Gamma of Γ.
How can you make you portfolio gamma-neutral?

k Buy/sell wT options that have a gamma of ΓT .
The combined position has a Gamma of: ΓΠ = wT ΓT + w Γ.

k To make it gamma-neutral you need to choose wT appropriately.
0 = wT ΓT + Γ ⇔ wT = −Γ/ΓT
Adjusting Gamma changes the Delta of the portfolio → Delta corrections.
The Gamma-hedge needs to be re-balanced.
Delta-neutrality: Protection against small changes in S.

Gamma-neutrality: Protection against large changes in S.
Vega (ν)
Vega, ν, is the rate of change of the value of the derivative w.r.t. a change
in the underlying (asset) volatility.
Large vega → The derivative is very sensitive to changes in the volatility.
Vega is bigger for at-the-money options. T
∂f √
In a Black-Scholes world: ν = = S0 T N 0 (d1 )
∂σ
2
where N 0 (x ) = √1 e−x /2 .
2π
Making a portfolio Vega-neutral

n
νΠ = ∑ wi νi
i =1
Hedging vega risk → νΠ = 0.
Underlying asset (e.g., the stock) has a vega of zero.

k It cannot be used to hedge vega risk.
To hedge vega risk, we need to take a position in a derivative.

Making a portfolio Vega-neutral (cont’d)
Assume that you hold a portfolio that has a vega of ν.
How can you make you portfolio vega-neutral?

k Buy/sell wT options that have a vega of νT .
The combined position has a vega of: νΠ = wT νT + w ν.

k To make it vega-neutral you need to choose wT appropriately.
0 = wT νT + ν ⇔ wT = −ν/νT
A gamma-neutral portfolio is not necessarily vega-neutral.

k At least two options are needed to make a portfolio gamma and
vega-neutral.
Vega-neutrality: Protection against changes in σ.

Delta, Gamma and Vega simultaneous neutrality
Consider a delta neutral portfolio (i.e. ∆Π = 0), with ΓΠ = −5, 000 and
νΠ = −8, 000.
There are two options that can be traded.

Option 1: ∆1 = 0.6, Γ1 = 0.5, ν1 = 2.0
Option 2: ∆2 = 0.5, Γ2 = 0.8, ν2 = 1.2
Your aim is to achieve delta, gamma and vega simultaneous neutrality.

k Create a new portfolio Π0 by adding w1 units of option 1 and w2 units of option 2
to your initial portfolio.
0 0
k Choose w1 and w2 so that ΓΠ = 0 and νΠ = 0.
Hence: −5, 000 + 0.5w1 + 0.8w2 = 0

−8, 000 + 2.0w1 + 1.2w2 = 0
Solving this system of equations we get: w1 = 400 and w2 = 6, 000.

Delta, Gamma and vega simultaneous neutrality (cont’d)
Adding 400 units of option 1 and 6,000 units of option 2 to our portfolio
changes the delta of the portfolio!
The delta of your portfolio is:

∆Π = 0 + 400 · 0.6 + 6, 000 · 0.5 = 3, 240
0
To make the portfolio delta-neutral we buy/sell w3 units the underlying

asset.
3, 240 + w3 · 1 = 0 ⇔ w3 = −3, 240
i.e. we sell 3,240 units of the underlying asset.

Theta (Θ)
Theta, Θ, is the rate of change of the value of the derivative w.r.t. time.
Calls: Θc = ∂∂ct Puts: Θp = ∂∂pt
Theta is also referred to as time decay.
In a Black-Scholes (-Merton) world:

S0 N 0 (d1 )σ
Calls: Θc = − √ − rKe−rT N (d2 )
2 T
S0 N 0 (d1 )σ
Puts: Θp = − √ + rKe−rT N (−d2 )
2 T
2
where N 0 (x ) = √1 e−x /2 .
2π
Time is measured in years.

k To obtain Θ per calendar (trading) day, we divide by 365 (252).

Theta (Θ)
Θ is usually negative (except in-the-money put).

Hedging in practice
Traders ensure that their portfolio is delta-neutral at least once a day.
Whenever the opportunity arises, they improve gamma and vega.

k Difficult to find options that can be traded in the volume required at
competitive prices.
As portfolio becomes larger, hedging becomes less expensive.

k Economies of scale in hedging.
Also sensible to run frequent portfolio analysis:

k Testing the effect on the value of the portfolio of different assumptions
concerning asset prices and their volatilities.

Implied Volatility and Volatility Smile

Implied volatility
Black-Scholes option prices: O = f (S , K , T , r , σ).
k We can observe S, K , T and r , but not σ.
Implied volatility (IV): The volatility for which the Black-Scholes price is
equal to the market price.
k O mkt = O BS .
k For example, in the case of calls:
O mkt = S0 N (d1 ) − Ke−rT N (d2 ),
ln(S0 /K )+(r +σ2 /2)T √
where d1 = √ and d2 = d1 − σ T .
σ T
k No closed-form solution: Use numerical methods or trial & error.
One-to-one correspondence between price and IV.

k Option value is monotonically related to IV (if ↑ O then ↑ IV ).
k Often IV and not dollar prices are quoted.
IV is forward looking.
The numerical search
Obtain data on:

k Option price (c /p), underlying asset price (S0 ), strike (K ), interest rate (r ),
time-to-maturity (T ).
Start with an arbitrary (but reasonable) volatility guess (e.g., the standard
deviation of the underlying asset).
Calculate the model option price and compare it with the market price.
k If c mkt (K , T ) > c BS and pmkt (K , T ) > pBS , we have to increase the guess
of asset volatility to match the market and model price.
The implied volatility is specific to strike K and maturity T .

k It cannot be used to price options with other K and/or T .
k One implied volatility can only be used to price one option.

Put-call parity revisited
The following two equations hold by arbitrage:

BS prices : pBS + S0 e−qT = c BS + Ke−rT
Market prices : pmkt + S0 e−qT = c mkt + Ke−rT
Subtracting the two equations from one another:

pBS − pmkt = c BS − c mkt
Considering the same strike (K ) and time-to-maturity (T ):

k Puts and calls should have identical dollar pricing errors.
k The IV derived from pmkt must be the same as that from c mkt .
k The volatility smile derived from pmkt must be the same as that from c mkt .
k The volatility term structure derived from pmkt must be the same as that
from c mkt .
Volatility smile: Relation between volatility and strike.

Volatility term structure: Relation between time-to-maturity and strike.
!
!
The Black-Scholes model and implied volatility !
!
!
!
!
!
!
!
The Black-Scholes model assumes that σ is constant, both across! K & T.
!Strike!Price!
!
!
!
!
!
IV! !
IV! !
!
!
!
!
!
!
!
!
!
!
!
!
!
!
!
! Time&to&maturity!
! !Strike!Price!
!
!
!
IV! !
This is not observed in practice!
k Indicates that the option pricing model cannot be true.!

The volatility smile for FX options
Indicates that the Black-Scholes model cannot be true!
IV is relatively low for at-the-money options and it increases as we move

in- or out-of-the-money.

Where does the implied distribution come from?
Risk-neutral valuation.
k Binomial tree: p is the risk-neutral probability of an up move.
k (p · fu + (1 − p ) · fd ) is the risk-neutral expected payoff.
k e−rT (p · fu + (1 − p ) · fd ) is the value of the option.
In continuous time, the same principle holds:

c = e−rT Ê [max (ST − K , 0)]
Z ∞
= e−rT (ST − K )f̂ (ST )dST
K
∂c
= −e−rT
R∞
First derivative of the option value w.r.t. K : ∂K K f̂ (ST )dST
2
Second derivative of the option value w.r.t. K : ∂∂Kc2 = e−rT f̂ (K )
∂2 c
Hence: f̂ (K ) = erT
∂K 2
Implied distribution for FX options
From the volatility smile, we can compute the distribution of the underlying
asset price at a future time (for fixed T ).
k It is the market’s statement of the risk-neutral distribution.
k Black-Scholes model assumes that prices follow a log-normal distribution.
We observe that:
1 Both tails are ’fatter’ than the log-normal distribution.
2 Implied distribution is ’more peaked’ than the log-normal one.
The volatility smirk for equity options

Implied distribution for equity options
The left tail is heavier & the right tail is less heavy than in the log-normal case.

Implied volatility term structure
In addition to calculating a volatility smile, traders also calculate a term

structure for implied volatility.
This shows the variation of implied volatility with time-to-maturity.
The volatility term structure tends to be downward-sloping when volatility

is high and upward sloping when it is low.

Why is there a volatility smile & a volatility term structure?
Black-Scholes model implies a constant σ across both K and T .

k This does not hold in practice!
Where does the option pricing model go wrong?
1 Stock price does not evolve continuously.

k Markets are closed overnight.
k Prices can exhibit sudden jumps.
2 Volatility for asset is stochastic.
3 Supply and demand.

k Traders often require put protection.
k Frequently prepared to sell upside calls to this end.
Summary
We reviewed the following topics:

k The Greeks.
k Implied volatility.
k Volatility smiles and their (likely) causes.
In the next lecture we will cover ’Hedging, Portfolio Insurance and

Cascade Theory’.

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Financial Derivatives

Greeks and Volatility Smile

Dr Eirini Konstantinidi & Dr Ser-Huang Poon

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 1 / 51

We will also look at discuss implied volatility.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 2 / 51

Video 1: Intended learning outcomes.

Video 1: Hedging - Setting the stage

Video 2: Greeks and hedging

Video 3: Implied volatility and the volatility smile.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 3 / 51

By the end of this lecture you should be able to:

Understand what hedging and what a good hedge is in our setting.

Perform hedging using greeks.

Understand, discuss and calculate implied volatility.

Discuss the volatility smile/skew.

Explain why we may be observing a volatility smile/skew.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 4 / 51

Hull (6th Edition): Chapter 15 & 16.

Hull (7th Edition): Chapter 17 & 18.

Hull (8th Edition): Chapter 18 & 19.

Hull (9th & 10th Edition): Chapter 19 & 20.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 5 / 51

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 6 / 51

What is the Black-Scholes call value?

Following these steps, the Black-Scholes call value is $240,000.

No problem if the stock price at maturity is low, i.e. below K = $50.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 8 / 51

Buy 100,000 shares immediately.

No problem if future stock price is high, i.e. above K = $50.

100, 000 · (ST − S0 ) = −900, 000.

The naked and the covered positions are both sub-optimal!

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 9 / 51

The stop-loss strategy involves:

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 10 / 51

Total costs of this strategy appear to be: Q = max(S0 − K , 0)

This reasoning is incorrect.

In practice, we buy (sell) the stocks at a price K + ε (K − ε).

The stop-loss strategy does not work well in practice.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 12 / 51

Greeks: Sensitivity factors.

The following partial derivatives are useful for hedging purposes:

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 13 / 51

Delta, ∆, is the rate of change of the derivative price (call, c or put p

Delta is important for hedging purposes.

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 14 / 51

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 15 / 51

Delta is closely related to the Black-Scholes (-Merton) analysis.

Consider a non-dividend paying stock whose price a GBM:

In this case, the delta of European stock-options is:

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 16 / 51

Delta hedging involves maintaining a delta-neutral portfolio.

Let a portfolio Π consist of n assets whose price depends on a single

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 17 / 51

Consider a portfolio consisting of one option and w stock stocks.

The portfolio delta is: ∆Π = w option ∆option + w stock ∆stock

This means that: