Derivatives

Tutorial: The Greeks

Question 1

An investor has written 100 European call options (K = $20, T = 1) on non-dividend paying

Carlton Ltd. shares. The current share price is $15, the volatility of Carlton shares is 20% per

annum, and the risk-free rate is 10% per annum. Each option entitles the holder to buy one

Carlton share. Find the delta of each option and explain how the investor could delta hedge

his exposure.

Question 2

A financial institution has the following portfolio of over the counter options on XYZ

Corporation shares:

Option Type Position and Number Delta

Call Long 1000 0.25
Call Short 300 0.85
Put Long 400 -0.40

The current XYZ stock price is $30. An exchange traded call option with a delta of 0.6

currently sells for $6. Each option covers one XYZ share.

a) How could the investor delta hedge her exposure using the stock?

b) How could the investor delta hedge her exposure using the exchange traded call?

Question 3

Consider a 4 month put option on a stock index. The current value of the index is 305 points,

the strike price is 300 points, the dividend yield is 3% per annum, the risk-free rate is 8% per

annum and the volatility of the index is 25% per annum. Assume a Black-Scholes-Merton

world.
a) Find the delta, gamma, and theta of the option

b) Discuss your results in part (a).

N.B Theta calculation is an extension and is not examinable. The relevant formula can be located
on page 386 in the 8th edition.

Question 4

Consider a European call option on a non dividend paying stock when the stock price is

$10.00, the strike price is $12.00, the risk-free interest rate is 6% per annum, the volatility is

40% per annum, and there is 2 years to maturity? (Use the Black-Scholes-Merton model).

a) What is the current price of the option?

Now assume the stock price instantaneously changes to $10.10.

b) Use the delta of the option to estimate the value of the option after the change

c) Use the delta and gamma of the option to estimate the value of the option after the

change.

d) What is the exact value of the option after the change?

e) Comment on your results.

Question 5

Consider a portfolio consisting of n1 units of security1 (value V1, delta δ1, gamma Γ1) and

n2 units of security2 (value V2, delta δ2, gamma Γ2) where both securities are affected by

the same source of uncertainty being the price of an underlying stock. A traded call option on

the underlying stock has a delta δ3 and a gamma of Γ3.

a) What position in the call option is necessary to make the portfolio gamma neutral?

Hint: The gamma for the two asset portfolio is

b) What position in the stock is necessary to make the revised portfolio delta neutral?
Question 6

Suppose the current price of (non dividend paying) ABC Limited shares is $20 and in 3

months time it will be either $22 or $18. Assume the risk free interest rate is 12% per annum

and markets are frictionless. Assume you have a portfolio of 10,000 ABC shares and you

want to use portfolio insurance to protect the value of the portfolio from falling below $21

per share in 3 months time.

Hint: rather than buying long puts with a strike of $21, you are required to create a long put
synthetically. This can be done using the one period binomial model.

a) What steps should be undertaken now to protect the portfolio?

b) Show the cash-flows now and in 3 months time on the insured portfolio.

c) Hull suggests the following (slightly) different strategy – invest only the proceeds from

the sale of the stock in riskless bonds i.e. . Repeat part (b) under Hull's strategy

d) Comment on your results in parts (b) and (c).

Question 7

What does it mean to assert that the theta of an option position is -0.1 when time is measured

in years? If a trader feels that neither a stock price nor its implied volatility will change, what

type of option position is appropriate?