Topic 57 The Greek Letters - Answers

Question #1 of 17 Question ID: 439424
Call and put option values are most sensitive to changes in the volatility of the underlying when:
✗ A) both puts and calls are deep out-of-the-money.
✓ B) both calls and puts are at-the-money.
✗ C) both calls and puts are deep in-the-money.

✗ D) calls are deep out-of-the-money and puts are deep in-the-money.
Explanation
Vega measures the sensitivity of the option value to changes in volatility. Vega is at a maximum when calls and put
options are at-the-money.
References
Question From: Topic Area 4 > Topic 57 > LO 7
Related Material:
Key Concepts by LO
When an option's gamma is higher:
✗ A) a delta hedge will be more effective.
✓ B) a delta hedge will perform more poorly over time.
✗ C) delta will be lower.

✗ D) delta will be higher.
Explanation
Gamma measures the rate of change of delta (a high gamma could mean that delta will be higher or lower) as the
asset price changes and, graphically, is the curvature of the option price as a function of the stock price. Delta
measures the slope of the function at a point. The greater gamma is (the more delta changes as the asset price
changes), the worse a delta hedge will perform over time.
References
Related Material:
Key Concepts by LO
To create a delta-neutral portfolio, an investor who has written 5,000 call options that have deltas equal to 0.5 will be:
✗ A) short 2,500 shares in the underlying and be short 2,500 more options.
✓ B) long 2,500 shares in the underlying.
✗ C) long 2,500 shares in the underlying and short 2,500 more options.
✗ D) short 2,500 shares in the underlying.
Explanation
If the investor has written 5,000 call options, he then must go long 0.5 × 5,000 = 2,500 shares to create a delta
neutral position since the delta of a share is 1.
References
Related Material:
Key Concepts by LO
The deltas of puts and calls are most sensitive to changes in the underlying when:
✓ A) both calls and puts are at-the-money.
✗ B) both puts and calls are deep out-of-the-money.
✗ C) calls are deep out-of-the-money, but puts are deep in-the-money.
✗ D) both calls and puts are deep in-the-money.
Explanation
Call and put deltas are the most sensitive to changes in the underlying security (i.e., gammas are largest) when the
option is at-the-money.
References
Related Material:
Key Concepts by LO
Which of the following is the best interpretation of delta for an option? Delta is the change in the option price for:
✗ A) a change in the time until expiration of the option.
✗ B) an instantaneous change in interest rates.
✓ C) an instantaneous change in price of the underlying stock.
✗ D) an instantaneous change in the volatility of the underlying stock.
Explanation
Delta is the slope of the price function of the call option payoff diagram.
References
Related Material:
Key Concepts by LO
Gamma is the greatest when an option:
✓ A) is at the money.
✗ B) is deep in the money.
✗ C) has a shorter maturity.
✗ D) is deep out of the money.
Explanation
Gamma, the curvature of the option-price/asset-price function, is greatest when the asset is at the money.
References
Related Material:
Key Concepts by LO
An option dealer is delta hedging a short call position on a stock. As the stock price increases, in order to maintain
the hedge, the dealer would most likely have to:
✓ A) buy more shares of the stock.

✗ B) sell some the shares of the stock.
✗ C) short T-bills.
✗ D) buy T-bills.
Explanation
As the value of the underlying increases, the delta of a call option increases. This means more of the underlying
asset is needed to hedge the position.
References
Related Material:
Key Concepts by LO
Which of the following is FALSE?

I. The delta of forwards and futures is 1.
II. Gamma is largest when options are at-the-money.
III. Two problems using stop-loss trading on naked options are transaction costs and stock price uncertainty.
IV. For a delta-neutral portfolio, although opposite in sign, theta can serve as a proxy for gamma.
✗ A) II and IV only.
✗ B) I and III only.

✗ C) II only.
✓ D) I only.
Explanation
The delta of forwards is one. The delta of futures is not usually one. Two problems using stop-loss trading on naked
options are transaction costs and stock price uncertainty. Gamma is largest when options are at-the-money. For a
delta-neutral portfolio, although opposite in sign, theta can serve as a proxy for gamma.
References
Related Material:
Key Concepts by LO
Ronald Franklin, CFA, has recently been promoted to junior portfolio manager for a large equity portfolio at
Davidson-Sherman (DS), a large multinational investment-banking firm. He is specifically responsible for the
development of a new investment strategy that DS wants all equity portfolio managers to implement. Upper
management at DS has instructed its portfolio managers to begin overlaying option strategies on all equity portfolios.
The relatively poor performance of many of their equity portfolios has been the main factor behind this decision. Prior
to this new mandate, DS portfolio managers had been allowed to use options at their own discretion, and the results
were somewhat inconsistent. Some portfolio managers were not comfortable with the most basic concepts of option
valuation and their expected return profiles, and simply did not utilize options at all. Upper management of DS wants
Franklin to develop an option strategy that would be applicable to all DS portfolios regardless of their underlying
investment composition. Management views this new implementation of option strategies as an opportunity to either
add value or reduce the risk of the portfolio.
Franklin gained experience with basic options strategies at his previous job. As an exercise, he decides to review the
fundamentals of option valuation using a simple example. Franklin recognizes that the behavior of an option's value
is dependent on many variables and decides to spend some time closely analyzing this behavior. His analysis has
resulted in the information shown in Exhibits 1 and 2 for European style options.
Exhibit 1: Input for European Options
Stock Price (S) 100
Strike Price (X) 100
Interest Rate (r) 0.07
Dividend Yield (q) 0.00
Time to Maturity (years) (t) 1.00
Volatility (Std. Dev.)(Sigma) 0.20
Black-Scholes Put Option Value $4.7809
Exhibit 2: European Option Sensitivities
Sensitivity Call Put
Delta 0.6736 -0.3264
Gamma 0.0180 0.0180
Theta -3.9797 2.5470
Vega 36.0527 36.0527
Rho 55.8230 -37.4164
Franklin wants to know if the option sensitivities shown in Exhibit 2 have minimum or maximum bounds. Which of the
following are the minimum and maximum bounds, respectively, for the put option delta?
✗ A) -1 and 1.
✓ B) -1 and 0.
✗ C) -1 and no maximum bound.

✗ D) There are no minimum or maximum bounds.
Explanation
The lower bound is achieved when the put option is far in the money so that it moves exactly in the opposite direction
as the stock price. When the put option is far out of the money, the option delta is zero. Thus, the option price does
not move even if the stock price moves since there is almost no chance that the option is going to be worth
something at expiration.
References
Related Material:
Key Concepts by LO
Questions #10-11 of 17
Ronald Franklin, CFA, has recently been promoted to junior portfolio manager for a large equity portfolio at
Davidson-Sherman (DS), a large multinational investment-banking firm. He is specifically responsible for the
development of a new investment strategy that DS wants all equity portfolio managers to implement. Upper
management at DS has instructed its portfolio managers to begin overlaying option strategies on all equity portfolios.
The relatively poor performance of many of their equity portfolios has been the main factor behind this decision. Prior
to this new mandate, DS portfolio managers had been allowed to use options at their own discretion, and the results
were somewhat inconsistent. Some portfolio managers were not comfortable with the most basic concepts of option
valuation and their expected return profiles, and simply did not utilize options at all. Upper management of DS wants
Franklin to develop an option strategy that would be applicable to all DS portfolios regardless of their underlying
investment composition. Management views this new implementation of option strategies as an opportunity to either
add value or reduce the risk of the portfolio.
Franklin gained experience with basic options strategies at his previous job. As an exercise, he decides to review the
fundamentals of option valuation using a simple example. Franklin recognizes that the behavior of an option's value
is dependent on many variables and decides to spend some time closely analyzing this behavior. His analysis has
resulted in the information shown in Exhibits 1 and 2 for European style options.
Exhibit 1: Input for European Options
Stock Price (S) 100
Strike Price (X) 100
Interest Rate (r) 0.07
Dividend Yield (q) 0.00

Time to Maturity (years) (t) 1.00
Volatility (Std. Dev.)(Sigma) 0.20
Black-Scholes Put Option Value $4.7809
Exhibit 2: European Option Sensitivities
Sensitivity Call Put
Delta 0.6736 -0.3264
Gamma 0.0180 0.0180
Theta -3.9797 2.5470
Vega 36.0527 36.0527
Rho 55.8230 -37.4164
Which of the following is the best estimate of the change in the put option when the underlying equity increases by
$1?
✗ A) -$3.61.
✓ B) -$0.33.
✗ C) -$0.37.
✗ D) $0.67.
Explanation
The correct value is simply the delta of the put option in Exhibit 2.
The incorrect value -$3.61 represents the change due to the volatility divided by 10 multiplied by -1.
The incorrect value -$0.37 calculates the change by dividing the short-term interest rate divided by 100.
The incorrect value $0.67 represents the change in the call option.
References
Related Material:
Key Concepts by LO
Franklin computes the rate of change in the European put option delta value, given a $1 increase in the underlying
equity. Using the information in Exhibits 1 and 2, which of the following is the closest to Franklin's answer?
✗ A) 0.6736.
✗ B) 36.0527.
✗ C) -0.3264.
✓ D) 0.0180.
Explanation
The correct value 0.0180 is referred to as the put option's Gamma.
The incorrect value -0.3264 is the delta of the put option.

The incorrect value 0.6736 is the call option's delta.
The incorrect value 36.0527 is the put option's Vega.
References
Related Material:
Key Concepts by LO
As an option approaches expiration, the value of rho for a put option:
✗ A) decreases and tends toward zero.
✗ B) decreases and tends toward negative infinity.
✓ C) increases and tends toward zero.
✗ D) increases and tends toward infinity.
Explanation
Rho values for put options are always negative and approach zero as the option nears maturity.
References
Related Material:
Key Concepts by LO
Gamma-neutral hedging:
✗ A) decreases sensitivity to small changes in asset prices.
✓ B) decreases sensitivity to large changes in asset prices.
✗ C) increases sensitivity to large changes in asset prices.

✗ D) increases sensitivity to small changes in asset prices.
Explanation
Gamma-neutral hedging is designed to mitigate the effect of large changes in asset prices on delta-neutral positions
that are designed to protect against small changes in asset prices.
References
Related Material:
Key Concepts by LO
Which of the following is least accurate regarding a gamma hedge?
✗ A) Gamma hedges require less frequent rebalancing than delta hedges.
✓ B) More frequent rebalancing of a gamma hedge should result in higher returns.
✗ C) Gamma measures the change in delta.
✗ D) The gamma increases with larger changes in the stock price.
Explanation
Gamma measures the change in delta. Gamma becomes larger as the changes in stock price increase in absolute
value. Gamma hedging requires less frequent rebalancing than delta hedging. Less frequent rebalancing in a
gamma hedge can result in higher returns but also increases the position's volatility.
References
Related Material:
Key Concepts by LO
Which of the following is the best approximation of the gamma of an option if its delta is equal to 0.6 when the price of the
underlying security is 100 and 0.7 when the price of the underlying security is 110?
✗ A) 1.00.
✓ B) 0.01.
✗ C) 0.00.
✗ D) 0.10.
Explanation
The gamma of an option is computed as follows:
Gamma = change in delta/change in the price of the underlying = (0.7 - 0.6)/(110 - 100) = 0.01
References
Related Material:
Key Concepts by LO
How is the gamma of an option defined? Gamma is the change in the:
✓ A) delta as the price of the underlying security changes.
✗ B) vega as the option price changes.
✗ C) theta as the option price changes.
✗ D) option price as the underlying security changes.
Explanation
Gamma is the rate of change in delta. It measures how fast the price sensitivity changes as the underlying asset price
changes.
References
Related Material:
Key Concepts by LO
The following profit/loss diagram is for what type of position?

✗ A) Short put.
✗ B) Long put.
✗ C) Long stock, short call (covered call).
✓ D) Long stock, long put (portfolio insurance).
Explanation
The above diagram is for a long stock, long put strategy (portfolio insurance). The loss is limited to the cost of the
option while the potential upside profit is unlimited. Note that the portfolio insurance payoff diagram is identical to the
profit/loss diagram for a long call option, however a long call is not one of the answer choices.
References
Related Material:
Key Concepts by LO

Topic 57 The Greek Letters - Answers

Uploaded by

Copyright:

Available Formats

Topic 57 The Greek Letters - Answers

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Topic 57 The Greek Letters - Answers

Uploaded by

Copyright:

Available Formats

Question #1 of 17 Question ID: 439424

✗ A) both puts and calls are deep out-of-the-money.

✓ B) both calls and puts are at-the-money.

✗ C) both calls and puts are deep in-the-money.

Question From: Topic Area 4 > Topic 57 > LO 7

Question #2 of 17 Question ID: 439422

When an option's gamma is higher:

✗ A) a delta hedge will be more effective.

✓ B) a delta hedge will perform more poorly over time.

✗ C) delta will be lower.

Question From: Topic Area 4 > Topic 57 > LO 7

✓ B) long 2,500 shares in the underlying.

Question From: Topic Area 4 > Topic 57 > LO 3

Question #4 of 17 Question ID: 439418

✓ A) both calls and puts are at-the-money.

✗ B) both puts and calls are deep out-of-the-money.

✗ C) calls are deep out-of-the-money, but puts are deep in-the-money.

✗ D) both calls and puts are deep in-the-money.

Question From: Topic Area 4 > Topic 57 > LO 4

✗ A) a change in the time until expiration of the option.

✗ B) an instantaneous change in interest rates.

✓ C) an instantaneous change in price of the underlying stock.

✗ D) an instantaneous change in the volatility of the underlying stock.

Question From: Topic Area 4 > Topic 57 > LO 3

Question #6 of 17 Question ID: 439423

Gamma is the greatest when an option:

✗ B) is deep in the money.

✗ C) has a shorter maturity.

✗ D) is deep out of the money.

Question From: Topic Area 4 > Topic 57 > LO 7

Question #7 of 17 Question ID: 439411

✓ A) buy more shares of the stock.

Question From: Topic Area 4 > Topic 57 > LO 3

Question #8 of 17 Question ID: 439419

Which of the following is FALSE?

✗ B) I and III only.

Question From: Topic Area 4 > Topic 57 > LO 4

Question #9 of 17 Question ID: 439416

Exhibit 1: Input for European Options

Stock Price (S) 100

Strike Price (X) 100

Interest Rate (r) 0.07

Dividend Yield (q) 0.00

Time to Maturity (years) (t) 1.00

Volatility (Std. Dev.)(Sigma) 0.20

Black-Scholes Put Option Value $4.7809

Exhibit 2: European Option Sensitivities

Sensitivity Call Put

Delta 0.6736 -0.3264

Gamma 0.0180 0.0180

Theta -3.9797 2.5470

Vega 36.0527 36.0527

Rho 55.8230 -37.4164

✗ C) -1 and no maximum bound.

Question From: Topic Area 4 > Topic 57 > LO 3

Exhibit 1: Input for European Options

Stock Price (S) 100

Strike Price (X) 100

Interest Rate (r) 0.07

Dividend Yield (q) 0.00