INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.
COURSE:MBA-683-50-F12 Financial Engineering
cross-listed with FIN-410-50-F12 Derivative Securities
SEMESTER:I, 2012
ExercisesChapter 17
The Greek Letters – Portfolio Insurance
Konstantinos Kanellopoulos
19thNovember 2012
PART IEXERCISES FROM CHAPTER17
Exercise 1
What does it mean to assert that the theta of an option position is –0.1 when time is measured in years? If a trader feels that neither a stock price nor its implied volatility will change, what type of option position is appropriate?
Solution 1
A theta of -0.1 means that if Δt units of time pass with no change in either the stock price or its volatility, the value of the option declines by 0.1Δt. A trader who feels that neither the stock price nor its implied volatility will change should write an option with as high a negative theta as possible. Relatively short-life at-the-money options have the most negative thetas.
Exercise 2
The Black–Scholes price of an out-of-the-money call option with an exercise price of $40 is $4. A trader who has written the option plans to use a stop-loss strategy. The trader’s plan is to buy at $40.10 and to sell at $39.90. Estimate the expected number of times the stock will be bought or sold.
Solution 2
The strategy costs the trader 0.10 each time the stock is bought or sold. The total expected cost of the strategy, in present value terms, must be $4. This means that the expected number of times the stock will be bought or sold is approximately 40. The expected number of times it will be bought is approximately 20 and the expected number of times it will be sold is also approximately 20. The buy and sell transactions can take place at any time during the life of the option. The above numbers are therefore only approximately correct because of the effects of discounting. Also the estimate is of the number of times the stock is bought or sold in the risk-neutral world, not the real world.
Exercise 3
A financial institution has the following portfolio of over-the-counter options on sterling:
A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
a. What position in the traded option and in sterling would make the portfolio both gamma neutral and delta neutral?
b. What position in the traded option and in sterling would make the portfolio both vega neutral and delta neutral?
Solution 3
The delta of the portfolio is-1,000 x 0.50 - 500 x 0.80 - 2,000 x (-0.40) - 500 x 0.70 = -450The gamma of the portfolio is-1,000 x 2.2 - 500 x 0.6 - 2,000 x 1.3 - 500 x 1.8 = -6,000
The vega of the portfolio is -1,000 x 1.8 - 500 x 0.2 - 2,000 x 0.7 - 500 x 1.4 = -4,000
a. A long position in 4,000 traded options will give a gamma-neutral portfolio since the long position has a gamma of 4,000 x 1.5 = +6,000. The delta of the whole portfolio (including traded options) is then: 4,000 x 0.6 - 450 = 1,950. Hence, in addition to the 4,000 traded options, a short position of 1,950 in sterling is necessary so that the portfolio is both gamma and delta neutral.
b. A long position in 5,000 traded options will give a vega-neutral portfolio since the long position has a vega of 5,000 x 0.8 = +4,000. The delta of the whole portfolio (including traded options) is then 5,000 x 0.6 - 450 = 2,550. Hence, in addition to the 5,000 traded options, a short position of 2,550 in sterling is necessary so that the portfolio is both vega and delta neutral.
Exercise 4
A bank’s position in options on the dollar–euro exchange rate has a delta of 30,000 and a gamma of -80,000. Explain how these numbers can be interpreted. The exchange rate (dollars per euro) is 0.90. What position would you take to make the position delta neutral? After a short period of time, the exchange rate moves to 0.93. Estimate the new delta. What additional trade is necessary to keep the position delta neutral? Assuming the bank did set up a delta-neutral position originally, has it gained or lost money from the exchange-rate movement?
Solution 4
The delta indicates that when the value of the euro exchange rate increases by $0.01, the value of the bank’s position increases by 0.01 X 30,000 = $300. The gamma indicates that when the euro exchange rate increases by $0.01 the delta of the portfolio decreases by 0.01 X 80,000 = 800. For delta neutrality 30,000 euros should be shorted. When the exchange rate moves up to 0.93, we expect the delta of the portfolio to decrease by (0.93 - 0.90) X 80,000 = 2,400 so that it becomes 27,600. To maintain delta neutrality, it is therefore necessary for the bank to unwind its short position 2,400 euros so that a net 27,600 have been shorted. As shown in the theory, when a portfolio is delta neutral and has a negative gamma, a loss is experienced when there is a large movement in the underlying asset price. We can conclude that the bank is likely to have lost money.
Exercise 5
A portfolio is worth $90 million. To protect against market downturns, the managers of the portfolio require a six-month European put option on the portfolio with a strike price of $87 million. The risk-free rate is 9% per annum, the dividend yield is 3% per annum and the volatility of the portfolio is 25% per annum. The S&P 500 index stands at 900. The portfolio is considered to mimic the S&P 500 fairly closely.
1) If the fund manager decides to provide insurance by creating a synthetic option, what proportion of the initial portfolio should be sold and invested in risk-free securities in order to match the delta of the required “synthetic” option?
2) What happens if the value of the portfolio reduces to $88 million after one day?
3) What happens if the value of the portfolio increases to $92 million after one day?
Solution 5
If a put option from the market was used, insurance could be provided by buying 1,000 put option contracts on the S&P 500 with a strike price of $870. Nevertheless, in this case, a synthetic option will be created.
S₀ = 90, K = 87, r = 0.09, σ = 0.25, T = 0.5, q = 0.03
(1)The delta of the required option is initially
This shows that 32.15% of the portfolio should be sold initially to match the delta of the required option.
(2)In that case, the delta of the required option changes to -0.3679 and a further 36.79%- 32.15%=4.64% of the original portfolio should be sold.
(3)In that case, the delta of the required option changes to -0.2787 and 32.15%-27.87%=4.28% of the original portfolio should be repurchased.
Exercise 6
A fund manager has a portfolio that is worth $360 million with a beta of 1.5. The value of the S&P 500 is 1,200, and the portfolio manager would like to buy insurance against a reduction of more than 5% in the value of the portfolio over the next six months. The risk-free interest rate is 6% per annum. The dividend yield on the portfolio is 4% and on the S&P 500 is 3%, and the volatility of the index is 30% per annum.
a) If the fund manager buys traded European put options, how much would the insurance cost?
b) Explain carefully alternative strategies open to the fund manager involving traded European call options, and show that they lead to the same result.
c) If the fund manager decides to provide insurance by keeping part of the portfolio in risk-free securities, what should the initial position be?
Solution 6
When the value of the portfolio goes down 5% in six months, the total return from the portfolio, including dividends, in the six months is -5 + 2 = -3% i.e., -6% per annum. This is 12% per annum less than the risk-free interest rate. Since the portfolio has a beta of 1.5 we would expect the market to provide a return of 8% (because 8%*1,5=12%) per annum less than the risk-free interest rate, i.e., we would expect the market to provide a return of 6%-8%=-2% per annum. Since dividends on the market index are 3% per annum, we would expect the market index to have dropped at the rate of x where x+3=-2% or x=-5% per annum or -2.5% per six months; i.e., we would expect the market to have dropped to 0.97*1200=1170. The portfolio is 300,000 times the index (300,000*1,200 = 360,000,000). Therefore, a total of 450,000 = (1.5 X 300,000) put options on the S&P 500 with exercise price 1170 and exercise date in six months are required.
a) S₀ = 1200, K = 1170, r = 0.06, σ = 0.3, T = 0.5, q = 0.03
Hence:
The total cost of the insurance is therefore 450,000 X 76.28 = $34,326,000
b) From put-call parity
or
This shows that a put option can be created by selling (or shorting) e-qT of the index, buying a call option and investing the remainder at the risk-free rate of interest. Applying this to the situation under consideration, the fund manager should:
1)sell 360e-0.03x0.5 = $354.64 million of stock
2)buy call options on 450,000 times the S&P 500 with exercise price 1170 and exercise date in six months
3)invest the remaining cash at the risk-free interest rate.
This strategy gives the same result as buying put options directly.
c) The portfolio is 50% more volatile than the S&P 500. When the insurance is considered as an option on the portfolio the parameters are as follows:
S₀ = 360, K = 342, r = 0.06, σ = 0.45, T = 0.5, q = 0.04
This indicates that 35.5% of the portfolio (i.e., $127.8 million) should be sold and invested in riskless securities.
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