Risk Management and

Derivatives
Lecture10:
Options 3, put-call parity,
trading strategies and delta
hedging
1

Unit Outline
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures 1
Week 7: Forwards and Futures 2
Week 8: Mid-Semester Exam
Week 9: Forward Rate Agreements (FRAs) and Swaps
Week 10: Reflective Practice and Options 1 (intro and binomial model)
Week 11: Options 2 (Black-Scholes-Merton model)
Week 12: Options 3 (put-call parity, trading strategies and delta
hedging)
Week 13: Derivative Disasters
Week 14: Revision
2

Lecture Content
Put-Call Parity
Trading Strategies
Delta Hedging

Readings:
Hull et al. (2014), Ch. 10: 10.4, Ch. 11 and Ch 17: 17.1,
17.2 and 17.4 (skim 17.3 for interest)

Put-Call Parity
Defined:
A principle referring to the static price relationship, given a
stock's price, between the prices of European put and call options
of the same class (i.e. same underlying, strike price and
expiration date). This relationship is shown from the fact that
combinations of options can create positions that are the same as
holding the stock itself. These option and stock positions must all
have the same return or an arbitrage opportunity would be
available to traders. Any option pricing model that produces put
and call prices that don't satisfy put-call parity should be rejected
as unsound because arbitrage opportunities exist Investopedia.
(http://www.investopedia.com/terms/p/putcallparity.asp)

Mathematically:

Put-Call Parity
Consider
the payoffs for

Payoffs for Put-Call Parity

Portfolio A

Long Call ()
Long the Bond ()

Total

Portfolio B

Long Put ()
Long the Stock ()

Total
Both portfolios
generate the same returns in the states when

and when

Put-Call Parity
Given
that

Payoffs for Put-Call Parity

Portfolio A

Long Put ()

Total

Portfolio B

Long Call ()
Long the Bond ()
Short the Stock ()

Total

Put-Call Parity
Using
payoff diagrams for

Long Call

Payoff

Long Bond

Synthetic Put:
Long
ST Call, Long Bond and Short St

Short Stock

Put-Call Parity
Given
that

Payoffs for Put-Call Parity

Portfolio A

Long Call ()

Total

Portfolio B

Long Put ()
Long the Stock ()
Short the Bond ()

Total

Put-Call Parity
Using
payoff diagrams for

Payoff

Long Stock Synthetic Call:

Long Put, Long Stock and Short Bo

Long Put

ST

Short Bond

Put-Call Parity
Example:

1.Solve for d1 and d2

2.Compute N(d1) and N(d2) using tables

3.Price Call Option

10

Put-Call Parity
Example:

1.Solve for d1 and d2

2.Compute N(-d1) and N(-d2) using tables

3.Price Put Option

11

Put-Call Parity
Example:

Using Put-Call Parity and noting and

and

12

Trading Strategies
Call Option and Stock: Profit Diagrams

Profit

Profit

Long
Stock

Long
Call

Short
Put
K
K

ST

Short
Call

ST

Long
Put

Short
Stock

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Trading Strategies

Profit

Long
Stock

Long
Call

Profit

Put Option and Stock: Profit Diagrams

Short
Put
K
ST

Long
Put

ST

Short
Stock

Short
Call

14

Trading Strategies
Bull Spread
Buying a Call with K1
and Selling a Call with K2
where K2 > K1
Profit

Long
Call
Bull
Spread
K1
K2

ST

Notes:
c1 > c2 because K1 < K2
Profits in up Bull market
Limited upside and limited downside
Can be established for options with
differing degrees of moneyness

Short
Call

15

Trading Strategies
Bear Spread

Profit

Buying a Put with K2

and Selling a Put with K1
where K2 > K1

K1
K2

ST

Notes:
p1 < p2 because K1 < K2
Profits in down Bear Market
Short
Put
Limited upside and limited downside
Bear Can be established for options with
Spread
differing degrees of moneyness

Long
Put

16

Trading Strategies
Butterfly Spread
Buying a Call with K1
and Buying a Call with K3
and Selling two Calls with K2
where K3 > K2 > K1

Profit

Long
Call

K1

K2

Long
Call

K3
ST

Notes:
c1 > c2 > c3 because K1 < K2 < K3
If current stock price is K2, the butterfl
Butterfly spread profits from limited market
Spread
movement.
Limited upside and limited downside

2 x Short
Call
17

Trading Strategies
Straddle
Buying a Call with K
and Buying a Put with K

Profit

Long
Call
Bottom
Straddle

K
ST
Long
Put

Notes:
Profits from large movements in price
in either direction
Opposite (sold call and put) is a top
straddle that profits from limited price
movement

18

Trading Strategies
Strip
Buying a Call with K
and Buying two Puts with K

Profit

Long
Call

Strip

Notes:
Profits from large movements in price
in either direction, but greater gain is
from price decreasing

ST
2 x Long
Put

19

Trading Strategies
Strap
Buying two Calls with K
and Buying a Put with K

Profit

2 x Long
Call
Strap

Notes:
Profits from large movements in price
in either direction, but greater gain is
from price increasing

ST
Long
Put

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Trading Strategies
Strangles

Profit

Buying a Put with K1

and Buying a Call with K2
where K2 > K1
Long
Call
Strangle

K1

K2
ST

Long
Put

Notes:
Profits from large movements in price
in either direction
Downside is less than the Straddle
Opposite (sold call and put) is a top
straddle that profits from limited price
movement

21

Delta Hedging
The Greeks
An Option position is risky as the price of the option changes with
changes in the underlying factors that affect price.

Stock Price (delta and gamma)

Time (theta)
Volatility (vega)
Risk-free Rate (rho)

The Greeks (as indicated in brackets) measure the sensitivity of

an option to changes in these factors.
We have measured delta already, will examine how a position in
an options contract can be hedged against small changes in
price.
Note that delta hedging is not perfect. To correct, a gamma hedge
can be undertaken. However, just as we focused on duration for
hedging bonds, we focus on delta hedging for options.

22

Delta Hedging
Example:

Profit

A European Call on 100,000 shares with K = 50 was sold

for $300,000.
S0 = 49, r = 0.05, T = 20/52, = 20% and = 13%
Black-Scholes-Value = $240,000; therefore theoretical
profit = $60,000
Problem: Profit may not be realised as stock price moves
Naked Position
up
An unhedged option position
300,000
If ST < 50, profit = $300,000
53
However, if ST > 50, profit <
S
50
$300,000
If ST > 60, loss = $700,000
T

Short
Call

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Delta Hedging
Covered Position
Buy 100,000 stocks
If the option is exercised, simply handover the stocks
However, if stock price falls
Profit

Long
Stock

300,000

53
50

-4,600,000
-4,900,000

Covered Position

ST

Short
Call

With the 100,000 stocks

If ST > 50, profit = $400,000.
However, if ST < 49, profit <
$300,000
If ST = 0, loss = $4,600,000
Not a good hedge
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Delta Hedging
Delta

Measures the change in the options price for a change

in the stocks price. Formally, for a call

If , then option price changes by approximately 60% of

the change in the stock price.
For small changes, is reasonably
accurate for small changes in price.
Option
slope =
Price
However, as the change becomes
larger, becomes less accurate.
This is where gamma would be used.
Stock25
Price

Delta Hedging
Where
have we seen ?

Binomial Model

Black-Scholes-Merton Model

Note: as stock price changes, the changes as well.

Hence, to be delta hedged, the portfolio must be
rebalanced as the stock price changes.
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Delta Hedging
Example:
Black-Scholes-Merton Model

S0
1
0 S0
0

27

Delta Hedging
Example: Delta Hedging with Weekly Rebalancing

28

Two-Step Binomial Model

.
Example,

Vu = 0.5075 x 22 2.03
= 9.135
r = (9.135/8.870 1) x
12/3
0.12
Vu* = 0.7273 x 22 2.03
= 13.971
22
V* = 0.5075 x 20
1.28
= 8.870

20

f=
1.28

fu =
2.03
18
fd =
0
Vu = 0.5075 x 18 0
= 9.135
r = (9.135/8.870 1) x
12/3
0.12

24.2
fuu =
3.2

19.8
fud = 0

Vuu = 0.7273 x 24.2

3.20
= 14.401
r = (14.401/13.971
1) x 12/3
0.12

Vud = 0.7273 x 19.8 0

= 14.401
r = (14.401/13.971
1) x 12/3
0.12

16.2
fdd =
0

29

Delta Hedging
Portfolio
Delta

The delta of a portfolio of options that are all based on

the same underlying asset is

Recall

30