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4 Cards in this Set
- Front
- Back
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Explain the meanings of the Greeks: Delta Theta Vega Rho |
Delta: The sensitivity of the option price to changes in the price of the underlying security. This is used in hedging when one takes an option position to hedge out fluctuations in the underlying security. For a call option, the value of the call increases as the underlying asset increases in value, so delta is positive. For a put option, the value decreases as the underlying increases, so delta is negative. Theta: The sensitivity of the option value to the passage of time. As an option approaches expiration, its value declines. This is known as time decay. Vega: The sensitivity of the option value to changes in volatility of the underlying security. This is an extremely important input as changes in volatility can have a dramatic impact on the value of the option. Both call and put options increase in value as volatility of the underlying increases. Rho: Sensitivity of the option to changes in the risk free rate. This is a very muted input for option pricing as changes in the risk free rate do little to effect the value of the option. |
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Describe the effects on an options delta for both calls and puts if the option is: 1) Either deep in or out of the money 2) Approaching maturity pg 82-84, derivs |
1) The important thing to remember here is that the slope of the "value prior to expiration line" is equal to the delta of the option. If you visualize the chart that shows the value of a call and put option, the VPTE line is a curve that lies just above the elbow for calls, and a curve that lies just below the elbow for puts. Therefore, a call option delta is close to 0 the further it is out of the money, and closer to 1 the further it is in the money (the slope increases as price increases). For a put, the delta is close to 0 when the option is further out of the money (higher underlying) and close to -1 when the option is in the money. 2. This depends on if the option is in or out of the money. For both calls and puts, if the option is out of the money, the option will approach 0 as time passes. If the options are in the money, call deltas will approach 1 with the passage of time and puts will approach negative 1 with the passage of time |
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What is gamma? At what point is it highest? What implications does it have for hedging? pg 86, derivs |
Gamma is the sensitivity of delta to a change in the underlying asset. Essentially it is a way of quantifying the difficulty of delta hedging because if delta is highly sensitive to changes in the underlying asset (high gamma), the hedge will need to be rebalanced more often.
Gamma for both call and put options is highest when the asset is closest to the strike price, and gamma decreases and the option becomes more in or out of the money. Conceptually this means that deltas a less sensitive to changes in the underlying asset as the option grows further in or out of the money. |
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What effect does cash flows generated by an asset have on options on that asset? pg 86-87, derivs |
The way to think about this is by thinking about the retention rate and its effect on growth. If the company has a high retention rate (low dividends), the growth prospects of the stock are higher and thus the price will likely increase (positive for calls options, neg for puts). If the retention rate is low (high dividends) the growth prospects of the stock are low and thus will hurt the stock price (pos for puts, neg for calls). |
