Assignment: Delta Hedging – Futures/Forwards/Options

Assumptions from information given and key information:

 I employ a delta neutral strategy on short dated equity options on the top 40
 Dynamic delta hedging involves adjusting the delta of an option position due to price
changes in the underlying security (the top 40 index).
 Delta neutral hedging aims to hedge against small changes in the underlying asset.
1. Both future and forward contracts are agreements to buy or sell an asset for a certain
price at a certain time (3 months). The key feature of concern with a forward contract
is the forward is settled at the end of the contract. This settlement is usually either
delivery or a cash settlement. Futures are settled daily by the clearing house. The
contract is usually closed out prior to maturity and there is a range of delivery dates. As
futures present similar characteristics of frequent margin adjustments, dynamic hedging
is better suited to futures.
2. Static hedging is a hedge and forget strategy i.e. the position is initially delta neutral
hedged and then not rebalanced throughout the period when the delta changes. A static
hedge would be used if you are confident in there being very little price movement
through a period and no interest changes. As previously mentioned, futures involve
daily margin adjustments. A forward instead is bought initially and then locked into a
position till maturity. This feature would better suit a static hedge.
3.
a. delta = 0.5, the delta of a futures contract = 𝑒 𝑟(𝑇−𝑡) . t = 0, resulting in 𝑒 𝑟𝑇 .
Take initial position of 100 units and asked to buy so assume we are short i.e.
0.5*-100=-50 units. We now need a delta neutral position so 0.5*-100 + x. 𝑒 𝑟𝑇
= 0. X = 50 * 𝑒 −𝑟𝑇 . T is 3/12 and r is 3 month T-bill rate (0.077 from Reserve
Bank). Therefore X = 49.90384 units. So 49.90384 futures.
b. The delta of a forward contract is 1 as it is settled at maturity. As above we
have -50 + x.1 = 0. Therefore x = 50. We need 50 forwards.
4. Interest rate risk on an option is of importance as when they rise, call prices rise (higher
interest rates increase call premium) and put options fall (higher interest rates decrease
put premiums). Rho measures the sensitivity to interest rate changes. Short dates
options have negligible interest rate risk compared to long dated options. Interest rate
risk would occur due to needing to borrow money to commit to the position. Hence I
would not consider hedging convexity and interest rate risk due to the short term of the
positions.
5. A option writer will write an option for one of three reasons: to insure/limit their
exposure to risk (a hedger), to make a gamble or to try to profit off speculation
(speculator) and trying to make riskless profit by simultaneously entering into
transactions in two markets (arbitrageur). For a hedger, the benefit arises from
protection against adverse price movements (forward and futures) and if invested with
futures, allowance for favourable price movements (there is an upfront fee – premium).
For speculation, the loss is limited to the premium paid for the option, while for futures,
potential gain and loss is very large. Here you have taken tacit bets of the situation.
Only in this case writers would be termed speculators or gamblers. Finally, arbitrage
option writers, go long on an under-priced position and short on an overpriced position
allowing for small riskless profit. As described above, option writers can also be
hedgers (trying to limit portfolio risk or arbitrageurs trying to make small riskless
profits).