Options

Financial Risk Management: IIT Jodhpur
Puneet Gupta
1
Option Greeks
Overview
• Delta – A measure of the rate of change in an options theoretical value for a one-unit change in the price of the underlying
security.
• Gamma – A measure of the rate of change in an options delta for a one-unit change in the price of the underlying. In other words,
the rate of change in delta.
• Vega - A measure of the rate of change in an option’s theoretical value for a one-unit change in implied volatility.
• Theta - A measure of the rate of change in an option’s theoretical value for a one-unit change in time to the option’s expiration
date.
• Rho - A measure of an option’s theoretical sensitivity to changes in the risk-free interest rate
Puneet Gupta
2
Delta
Concept and how does it change?
Call deltas are often also interpreted as an indicator of the probability of the option
finishing in-the-money. For this reason, a deep in-the-money option will have a
delta close to 1, and a deep out-of-the-money option will have a delta close to 0.
Puneet Gupta
3
Gamma
Concept and how does it change?
• Long call, long puts: Have positive gamma

• Short call, short puts: Have negative gamma
• Pure stock positions: Have no gamma, ie zero gamma.
For a deep in-the-money option, delta approaches 1 and gamma

approaches zero. Similarly delta for far out-of-the-money options will be
close to zero as delta is already zero.
Gamma is maximum at or near the exercise price, ie it is maximum when
the option is at-the-money.
Gamma change with stock price Gamma and time to maturity
Puneet Gupta
4
Delta hedging
Example
Periodic need for rebalancing as delta changes with the

change in stock price
Cost of hedging with the stock being bought high, sold low
How do we extend to gamma hedging?
Puneet Gupta
5
Vega
Overview
Vega is higher the further away we are from the exercise date. However,
vols of short dated options tend to change more than that of long dated
options during periods of big vol changes.
If we want to capture forward volatility, then we have to trade options

with the largest vega. If we want to trade the spot volatility, then we
have to trade options with largest gamma.
Puneet Gupta
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How will these Greeks behave for exotic options?
Extrapolating to non-vanilla options
• With non-vanilla options, e.g. Barrier options, path-dependent options, the profile of the greeks with respect to underlying
movements (spot, vol etc.) can become quite dynamic making it difficult to hedge/ monitor the risk.
Example of a delta profile for up and out call option
Puneet Gupta
7
Black Scholes Option pricing
Pricing formulae:
Call delta is N(d1) and the probability of finishing in the money is N(d2)
While deriving the BS pricing, the assumption made is stock price follows a lognormal
distribution with sigma constant.
Concept of implied volatility:

• If we reverse compute the sigma used in the BS pricing from the observed call/put
price, we would obtain what’s called implied volatility.
Where • This will be different from realized volatility, what you will compute if you use historical
K: strike price stock log returns.
S0: spot price
r: risk free rate
Puneet Gupta
8
Volatility smile
Overview
Equity vol smile/ skew
Volatility is not constant, in general for lower strikes, implied

volatility is lower
Often explained by demand for lower strike puts (crashophobia)

and a heavier left tail in the implied world.
Implied distribution vs lognormal distribution for Equity
Puneet Gupta
9
Volatility surface
Extending volatility smile to include time to maturity
• One dimension is time to maturity

• The other is the strike
Puneet Gupta
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Var for options
• Taylor based calcs

• Full reval based calcs
Puneet Gupta
11
Mortgage Backed securities
Overview
• Agency backed MBS

• Pass Through Prepayment risk
• Specified Pool
• TBA
• Collateralized Mortgage Obligation (CMO)
• Non Agency MBS Credit risk, Prepayment risk
• Key Agencies: GNMA, a government agency and FNMA, FHLMC government sponsored enterprises
• Agencies buy mortgages from backs and underlying mortgages packed into pools of Mortgage backed securities,
where in the investors receive principal and interest payment.
• With the agency guarantee, there is minimal credit risk and investors receive their share of cash flows from mortgages
excluding agency fees for guaranteeing and servicing mortgages. MBS coupons generally paid monthly.
• Key risk is then prepayment risk, With non-agency MBS credit risk comes in.
Puneet Gupta
12
Prepayment
More details on drivers/ impact of prepayment
Key prepayment drivers:

• Refinancing (low interest rates, age of mortgage/ burnout, size of loan)
• Turnover
• Defaults
For CMOs, prepayment risk borne in higher proportion by specific tranches

Variants of CMOs e.g. PO, IO only exist as well
PO only for example, receives only principal payments from the underlying mortgage pool. If faster prepayment, beneficial as cash flows received earlier
than anticipated.
Reverse true for IO only where not much interest payments available if prepayment rate is high.
Option adjusted spread: Expected return on MBS- Treasury risk free rate. Higher the OAS, more attractive is the MBS
Puneet Gupta
13

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Financial Risk Management: IIT Jodhpur

• Long call, long puts: Have positive gamma

For a deep in-the-money option, delta approaches 1 and gamma

Gamma change with stock price Gamma and time to maturity

Periodic need for rebalancing as delta changes with the

How do we extend to gamma hedging?

If we want to capture forward volatility, then we have to trade options

Example of a delta profile for up and out call option

Concept of implied volatility:

Volatility is not constant, in general for lower strikes, implied

Often explained by demand for lower strike puts (crashophobia)

Implied distribution vs lognormal distribution for Equity

• One dimension is time to maturity

• Taylor based calcs

• Agency backed MBS

• Non Agency MBS Credit risk, Prepayment risk

Key prepayment drivers:

For CMOs, prepayment risk borne in higher proportion by specific tranches

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