Instructor: Tingwei WANG

Email: tingwei.wang@dauphine.fr
Universit Paris-Dauphine
For Master 224
September 2014

Risk Management
Base asset
- Stocks

Volatility: standard deviation of return

VaR (Value at Risk)

- Bonds

Duration: sensitivity to interest rate change

credit risks

Risk Management of Derivatives

The value of a derivative depends on the value of

underlying asset and other relevant parameters

Greek letters describe the sensitivity of the value of a

derivative to the relevant parameters

The focus of risk management of derivatives portfolio

is on the Greek letters

Review of Derivatives Basics

What is forward/futures?
What is an option?
How to price forward/futures?
How to price an option?

Types of derivatives
Futures/Forward Contracts
- An obligation for both parties to exchange the underlying
asset for a pre-determined price
Swaps
- Exchange of cash flows of different characteristics
Options
- A right to buy/sell the underlying asset at the strike price

Forward
A forward contract is an agreement to buy or sell an

asset at a certain time in the future for a certain price (the

forward price)
It can be contrasted with a spot contract which is an

agreement to buy or sell immediately (outright purchase)

It is traded in the OTC market

Futures
Definition
- A futures contract is a standardized contract between two
parties to buy or sell a specified asset of standardized
quantity and quality for a price agreed upon today (the
futures price)
Specifications need to be defined
- What can be delivered
- Where it can be delivered
- When it can be delivered
Traded in exchange and settled daily

Forward Contracts vs Futures Contracts

FORWARDS
Private contract between 2 parties
Not standardized
Usually 1 specified delivery date
Settled at end of contract
Delivery or final cash
settlement usually occurs
Some credit risk
No basis risk
Predictible cash-flows

FUTURES
Exchange traded
Standardized contract
Range of delivery dates
Settled daily
Contract usually closed out
prior to maturity
Virtually no credit risk
Basis risk
Funding liquidity risk

Pricing Futures/Forward
Price of Futures contract
r ( T t )
- Without dividend: Ft St e
- With dividend:

Ft St e( r q )(T t ) Ft [St PV ( D)]er (T t )

Mark to market value of forward contract

r (T t )
( Ft ,T K )
- Long position: f e
- Short position: f

e r (T t ) ( K Ft ,T )

Example
ABC stock costs $100 today and is expected to pay a

quarterly dividend of $1.25. If the risk-free rate is 10%

compounded continuously, how much
is the 1-year forward price of ABC stock?
3

F0,1 100e 1.25e

0.1

i 0

0.025i

$105.32

Options: Call and Put

There are two basic types of options
- Call option
- Put option
Call option
- A call option gives the holder of the option the right to buy
an asset by a certain date for a certain price
Put option
- A put option gives the holder of the option the right to sell
an asset by a certain date for a certain price

Underlying Assets
Stocks
- Single stock, basket of stocks, stock indices,
Bonds
- Treasury bonds, interest rate (caplets and floorlets),
Currencies
- Exchange rate option
Commodities
- Agricultural products, metals, energy,
Futures contracts
- On stock indices, bonds, commodities,

Example: payoff of a call option

A European call option of Orange with a strike price

of 70 that expires in 6 months

Payoff ()

30
20

10

Terminal
stock price()

0
40
-10

50

60

70

80

90

100

Example: payoff of a put option

A European put option of Orange with a strike price

of 70 that expires in 6 months

Payoff ()

30
20

10

Terminal
stock price()

0
40
-10

50

60

70

80

90

100

Option Premium (Price)

Option gives one party the right to buy/sell the

underlying asset at the strike price while obligates

the other party to sell/buy the underlying asset upon
request
- Seller of the option is called the writer
- The writer should be compensated with a premium

Contrast with futures/forwards

- Futures/forwards bring obligations to both parties
- The initial value of futures/forwards can be set to zero

P&L of Options
P&L = Payoff Option Premium
Example: a European call option of Orange with a

strike price of 70 that expires in 6 months

P&L ()

30

How much is the option premium here?

20
Break-even price

10
0

40 50 60 70

Terminal
stock price()

80 90 100
-10

Moneyness
At-the-money option
- Spot stock price S is equal to the strike price K
In-the-money option
- Spot stock price S is larger than the strike price K
- Deep-in-the-money: S>>K
Out-of-the-money option
- Spot stock price S is smaller than the strike price K
- Deep-out-of-the-money: S<<K

Practical Issues: Dividends

If a company distributes dividends during the life of

the option, the stock price will be decreased by the

amount of dividends
- The strike price should be adjusted by the amount

dividends on the ex-dividend date

Example
- Consider a put option to sell 100 shares of a company for
$15 per share. Suppose that the company declares a $2
dividend. The strike price will be decreased by $2.

Practical Issues: Dividends

For exchange-traded options and many over-the-

counter stock options, the strike price will not be

adjusted in the event of dividend payment!
The option premium actually takes into account the

future dividend payment

- A call would be cheaper
- A put would be more expensive

Option Pricing (Single Stock/Index)

Suppose you have an option that allows you to buy a

stock at $20 one year later. There are only two

possible outcomes of the stock price. It will be $30
with 50% probability and $10 with 50% probability.
The expected return of the stock is 10%. How much
is the option worth today?
Traditional cash flow discounting

E[( X K ) ] 0.5 (30 20) 0.5*0

c

$4.55
1 re
1 10%

Law of One Price

If there exists one portfolio with exactly the same

payoff as the option, then the price of the portfolio

should be the same as the option price
- This indicates that option is replicable if such portfolio exists
- The portfolio is called replicating portfolio
- For base assets, replicating payoff is impossible because

the value of base assets rely on fundamental variables

What can be used in a replicating portfolio?

- Base assets: stocks, bonds, commodities, etc.

Replicating Option Payoff

The value of an option on stock can be decomposed

into exercise value and time value

- Exercise value: stock

- Time value: bond

Does there exist a portfolio composed of the

underlying stock and risk-free bonds that perfectly

replicates the payoff of the option?
- Assume we buy x units of stock and y units of risk-free

bonds and solve for x and y

Replicating Portfolio
Suppose you have an option that allows you to buy a

stock at $20 one year later. There are only two

possible outcomes of the stock price. It will be $30
with 50% probability and $10 with 50% probability.
Su 30, Sd 10, cu 10, cd 0
xSu yerf 1 30 20 x 0.5

rf
r f 1
y

5
e

xSd ye 0
The value of the replicating portfolio today is

V0 xS0 y 0.5 20 5e

rf

10 5e

rf

c0

Generalized case
At t=0, the stock price is S0 and risk-free rate is rf
At t=T, the stock price either goes up or down. If up,

the stock price is Su=uS0 and the call will be worth cu;
if down, the stock price is Sd=dS0 and the call will be
worth cd
Up

Su

S0
Replicating portfolio
cu cd
Down

Sd
x
rf T

xSu ye cu
Su S d

rf T
xSd ye cd
y e rf T cd Su cu Sd e rf T ucd dcu

Su S d
ud

Value of the call option

By law of one price, todays value of the call option

should be equal to todays value of the replicating

portfolio
cu cd
r f T ucd dcu
c0 V0 xS0 y
S0 e
Su S d
ud
e

rf T

rf T

e d
r T u e
cu e f
cd
ud
ud
rf T

rf T

(qu cu qd cd )

e f d
u e f d
where qu
, qd
ud
ud
r T

r T

Risk-neutral Probability
Interestingly, qu plus qd is equal to 1

e f d u e f
qu qd

1
ud
ud
The expected payoff of the call option is actually
calculated using q-probability rather than pprobability
rT

c0 e

rf T

rT

(qu cu qd cd ) e

rf T

E Q [c]

- Q-probability is called risk-neutral probability

- Under risk-neutral probability, the expected payoff is

discounted by risk-free rate and the expected return for all

assets is risk-free rate

Forward Pricing in Q-measure

The payoff of a long forward contract is

X ST F
The forward value today is the expected forward

payoff under risk-neutral probability measure

discounted by risk-free rate
f 0 e rT E Q [ ST F ]
e rT E Q [ ST ] e rT F
e rT e rT S0 e rT F
S0 e rT F

Multi-period Model
When the number of periods increases, the time

interval shrinks and the stock price movements

become smaller
Path distribution
- For n-period model, n+1 possible outcomes
- To reach the highest node, there is only one path: up, up,
up,all the way up
- To reach the lowest node, also only one path: down, down,
, all the way down

Continuous-time option pricing

When the number of periods approaches infinity, the

stock price moves continuously and terminal prices

span the whole set of positive numbers
If we let n go to infinity in the binominal pricing

formula, we get the continuous-time version of

option pricing formula
- First proposed by Black & Scholes (1973) using partial

differential equation

Black-Scholes Formula
European option on stock without dividend

c0 S0 N (d1 ) Ke rT N (d 2 )
p0 Ke rT N (d 2 ) S0 N (d1 )
ln( S0 K ) (r 2 2)T
where d1
,
T
ln( S0 K ) (r 2 2)T
d2
d1 T
T
N ( x) is the cumulative normal distribution function

Example
Current stock price is $42. A call with strike price $40

will expire in 6 months. The risk-free interest rate is

10% per annum and the volatility is 20% per annum.
What is the call price? If it is a put?
Solution
S0 42, K 40, r 0.1, 0.2, T 0.5
d1

ln( S0 K ) (r 2 2)T

0.7693, d 2 d1 T 0.6278

c S0 N (d1 ) Ke rT N (d 2 ) 4.76
p Ke rT N (d 2 ) S0 N (d1 ) 0.81

Generalized Black-Scholes Formula

Black-Scholes formula can only be applied to a

single stock with no dividend payments during the

life of option
We can generalize Black-Scholes formula to price an

European option on assets with intermediate cash

flows or other derivatives, e.g. stock with dividends,
currencies or futures contract

Generalized Black-Scholes Formula

Change S0 into prepaid forward price

c0 F0P N (d1 ) Ke rT N (d 2 )
p0 Ke rT N (d 2 ) F0P N (d1 )
ln( F0P K ) (r 2 2)T
where d1
,
T
ln( F0P K ) (r 2 2)T
d2
d1 T
T

Option on stocks w/ dividends

Continuous dividends (stock index)

F0P S0e qT
c0 S0 e qT N (d1 ) Ke rT N (d 2 )
p0 Ke rT N (d 2 ) S0e qT N (d1 )
where d1
d2

ln ( S0 e qT K ) (r 2 2)T

T
ln ( S0 e qT K ) (r 2 2)T

,
d1 T

Option on stocks w/ dividends

Discrete dividends

F0P S0 PV ( D)
c0 [ S0 PV ( D)]N (d1 ) Ke rT N (d 2 )
p0 Ke rT N (d 2 ) S0 N (d1 )
where d1
d2

ln[( S0 PV ( D) K ] (r 2 2)T

T
ln[( S0 PV ( D) K ] (r 2 2)T

,
d1 T

Options on Currencies
Continuous compounding interest rates

F0P x0 e
c0 x0 e

rf T

rf T

p0 Ke

rT

N (d1 ) Ke rT N (d 2 )
N (d 2 ) x0e

where d1
d2

ln ( x0 e

rf T

rf T

N (d1 )

K ) (r 2 2)T

T
ln ( x0 e

rf T

K ) (r 2 2)T
d1 T
T

Options on Futures Contract

Blacks Formula

F0P F0 e rT
c0 F0 e rT N (d1 ) Ke rT N (d 2 ) e rT [ F0 N (d1 ) KN (d 2 )]
p0 e rT [ KN (d 2 ) F0 N (d1 )]
where d1
d2

ln ( F0 e rT K ) (r 2 2)T

T
ln ( F0 e rT K ) (r 2 2)T

ln ( F0 K ) ( 2 2)T

d1 T

Factors that affect option price

From Black-Scholes formula,
c0 S0 N (d1 ) Ke rT N (d 2 ), p0 Ke rT N (d 2 ) S0 N (d1 )

where d1

ln( S0 K ) (r 2 2)T

, d 2 d1 T

T
we can see there are five factors that affect option
price
- Spot price of underlying asset (S0)
- Strike price (K)
- Maturity (T)

- Volatility ( )
- Risk-free interest rate (r)

How Factors Change Option Value

Factors (+)

Call option

Put option

Spot price of underlying asset

Strike price

Maturity

Volatility

Interest rate

Greek Letters
Greek letters describe the sensitivity of option price

to one of its determinants, ceteris paribus

- Measure sensitivity: partial derivatives

Greek letters are of great importance in risk

management
- They measure the risk exposure of holding an option to all

the possible factors

- Traders contruct hedging portofolio based on Greek letters

Delta
Delta (D) is the rate of change of the option price with

respect to the underlying asset price

Option price

Slope = D
ct
St

Stock price

Delta
Calculate delta
- Call option
rT

S
N
(
d
)

Ke
N (d 2 )
ct
t
1

Dt

N (d1 ) 0
St
St
- Put option
rT

Ke
N (d 2 ) St N (d1 )
ct

Dt

N (d1 ) 1 0
St
St
- Continuous proportional dividend
q (T t )
put
q (T t )
Dcall

e
N
(
d
),
D

e
[ N (d1 ) 1]
1
t
t

Discrete Delta
Continuous delta results in losses when asset price

either goes up or down

- Solution: discrete delta
Option price

cu

cu cd
D
Su S d

ct
cd
Sd

St

Su Stock price

 Compare with the replicating portfolio in binominal

tree model

cu cd

x S S
xSu yerf T cu

u
d

rf T
xSd ye cd
y e rf T cd Su cu Sd e rf T ucd dcu

Su S d
ud
c c
r T ucd dcu
c0 xS0 y u d S0 e f
Su S d
ud

c0 S0 N (d1 ) Ke rT N (d2 ) D0 S0 [e rT KN (d2 )]

stocks

bonds

Delta

Gamma
Gamma (G) is the rate of change of delta (D) with

respect to the price of the underlying asset

- Gamma addresses delta hedging errors caused by

curvature
Call price
C
C

Stock price

Gamma & Vega

Vega
Vega (n) is the rate of change of the option price with

respect to implied volatility

- Vega is always positive for vanilla options but not always for

exotic options

Real volatility V.S. Implied Volatility

- Real volatility: unobservable, calculated using a period of
historical returns
- Implied volatility: observable, backed out from vanilla option
prices using Black-Scholes formula

Constant volatility
In the Black-Scholes model, the volatility of the

underlying asset is constant, which is not true in the

real market

Volatility Smile

Volatility Surface

Implied
volatility

Maturity T
Moneyness K/S0

Theta

European Call Premium

Option
premium

Time value
Intrinsic value
Max(St-K,0)

K
Out-of-the-money

Stock price St

European Put premium

Option
premium

Negtive time value

pt ( K St ) ct K (1 e r (T t ) ) 0

Time value
Intrinsic value
Max(K-St,0)
K
In-the-money

Stock price St

Rho
Rho is the rate of change of the value of the option

price with respect to the interest rate

- For currency options there are 2 rhos

Calculations
- European call on non-dividend paying stock
rho(call ) KTe rT N (d2 ) 0
- European put on non-dividend paying stock
rho( put ) KTe rT N (d2 ) 0

Rho

Example: delta hedging

Principle
- Construct a self-financing portfolio with stocks and risk-free
bonds to replicate the value of an option
- Self-financing: no additional capital added to the portfolio
during the hedging process

Initiation
- At t=0, the bank sells an option and earns the option
premium C0
- Then the banks buys D 0 units of stocks and C0 D0 S0 units
of risk-free bonds

Delta hedging (Contd)

On day t, the portfolio value is
t Dt St Bt
On day t+1, before rebalancing the portfolio, the

portfolio value is1

t 1 Dt St 1 Bt e

252

At the end of day, the trade rebalances the portfolio

with the updated delta

t 1 Dt 1St 1 Bt 1

where Bt 1 t 1 Dt 1St 1

 Cumulative P/L of hedging (hedging error) is

et t Ct

The final P/L (total hedging error) is

eT T CT
DT 1ST BT 1e

1
252

max( ST K , 0)

Decomposition of option value change

Daily change of option value

Ct 1 (St 1 ) Ct (St ) Ct 1 (St 1 ) Ct (St 1 ) Ct (St 1 ) Ct (St )

Time value

Price risk

Ct ( St )
1 2Ct ( St )
2
Ct ( St 1 ) Ct ( St )
( St 1 St )
(
S

S
)
t 1
t
St
2 St 2
1
Dt ( St 1 St ) Gt ( St 1 St ) 2
2
Delta exposure Gamma exposure

Hedging error
Option value change
1
1
Ct 1 ( St 1 ) Ct (St )
Dt ( St 1 St ) Gt ( St 1 St ) 2
252
2
Hedging portfolio value change
t 1 t Dt (St 1 St ) Bt (e

1
252

1)

Daily Hedging error

t 1 ( t 1 t ) (Ct 1 Ct )
Bt (e

1
252

1)

1
1
Gt ( St 1 St ) 2
252 2

Delta of Futures/Forwards
Delta of futures contract
r ( T t )
D er (T t )
- Without dividend: Ft St e
- With dividend:

Ft St e( r q )(T t )

D e( r q )(T t )

Delta of forward contract

r (T t )
St D 1
- Long position: f Ke
- Short position:

f St Ke r (T t ) D 1

Greeks of a portfolio
Greeks of a portfolio are simply the weighted greeks

of each individual asset in the portfolio

Example: delta of a portfolio
- Suppose a portfolio consists of a quantity wi of asset i with
Di, the delta of the portfolio is given by
n

D p wi Di
i 1

Example
Suppose a bank has a portfolio of following assets:
- 1. A long position in 1000 call options with strike price 30
and an expiration date in 3 months. The delta of each
option is 0.55
- 2. A short position in 500 put options with strike price 20
and an expiration date in 6 months. The delta of each put
options is -0.3
- 3. A long position in 100 shares of underlying stocks
- 4. A short position in a forward contract on 200 shares of
underlying stocks
n

D p wi Di 1000 0.55 500 (0.3) 100 1 200 1 600

i 1

Gamma Neutral Portfolio

A delta-neutral portfolio is not gamma-neutral

because the underlying asset or forward/futures

contract on the underlying asset both have zero
gamma
Solution: use a traded option with gamma GT
- Suppose a portfolio has a gamma equal to G
- Adding the traded option, the portfolio gamma becomes
wGT G 0
w

G
GT

Example
A bank writes exotic options to its clients. It accumulates

a negative gamma of -6.000 but is delta-neutral. To

neutralize the negative gamma exposure, the bank
decides to buy call option with a delta of 0.6 and a
gamma of 1.50. Should the bank buy or sell this call
option? And how many?
Solution
G
6000
w

4000
GT
1.5
- The bank should buy 4000 call options

 After adding the call option to the portfolio, the delta

of the portfolio is not zero anymore!

D p 0 wDT 4000 0.6 2400

To make the portfolio delta-neutral again, the bank

should sell 2400 units of underlying asset or sell

certain amounts of forward/futures contract on this
asset

Vega Neutral Portfolio

The method of constructing a vega neutral portfolio

is the same as gamma neutral portfolio

Suppose a traded option has a vega of n T . To

neutralize a portfolio with vega n , the number of

option needed is
wn T n 0
w

n
nT

Gamma-vega Neutral
A gamma neutral portfolio is in general not vega

neutral, and vice versa

It is possible to make a delta neutral portfolio both

gamma neutral and vega neutral

- With one option, it is only possible to neutralize one greek

letter in addition to delta

- With two options, two greek letters can be neutralized at the
same time by solving 2 simultaneous equations

Example: gamma-vega neutral

A delta neutral portfolio has a gamma of -5,000 and a

vega of -8,000. A traded option has a gamma of 0.5, a

vega of 2.0 and a delta of 0.6. Another traded option has
a gamma of 0.8, a vega of 1.2 and a delta of 0.5.
Let w1 and w2 be the quantities of the two options

5000 0.5w1 0.8w2 0

8000 2.0w1 1.2w2 0

w1 400
D p 400 0.6 6000 0.5 3240

w2 6000

Delta, Theta and Gamma

Taylors expansion on the value of a portfolio

1 2
2
d
dt
dS
(
dS
)
t
S
2 S 2
1
dt DdS G(dS ) 2
2

Take expectation under Q on both sides

E Q [

d
dS 1
dS
] dt DSt E Q [ ] GSt2 E Q [( ) 2 ]

S
2
S

Under Q, the expected return of any asset is r

dS
d
E Q [ ] r dt , E Q [
] r dt
S

Contd
1
dS
rdt dt DrSdt GSt2 E Q [( )2 ]
2
S
dS
dS
dS
) E Q [( ) 2 ] E Q [ ]2 2 dt
S
S
S
dS
dS
E Q [( ) 2 ] 2 dt E Q [ ]2 2 dt (rdt ) 2 2 dt
S
S

Var (

1 2 2
rdt dt DrSdt GS dt
2

The value of a portfolio composed of derivatives

on a non-dividend-paying stock satisfies the

differential equation
1
rS D 2 S 2G r
2

Problems with Black-Scholes

Black-Scholes is a very nice model that is consistent

with all the properties of options and has a neat

solution to the option price
But, it is based on many strong assumptions that are

not realistic in the real market

- Log-normal distribution of stock price
- Continuous trading w/o transaction cost
- Constant volatility and interest rate