Delta Neuttal Hedging
Fourth AIMS International Conference on Management December 28-31, 2006
1
Practical Considerations in the Application of Delta Neutral Hedging
Paper Reference No: A553
T.V.Venkatarathna, Senior Consultant, Polaris Software Lab Limited,
Survey No.203/Part, Manikonda IT Park,
Hyderabad 500 019 venkat.tv@polaris.co.in Many financial institutions hold derivative instruments in their portfolio whose value changes in response to a change in the value of the underlying security. The option-pricing model developed by Black and Scholes (1973) indicates that a portfolio consisting of a risky asset and call options thereon can be balanced in such a way that the returns from the portfolio will approximate to a risk free rate of return. Ascertaining the right balancing mix between the units of the underlying security and the options thereon is the central theme of Delta hedging. This paper summarizes the guiding principles to design a Delta neutral portfolio and examines the practical considerations involved in the real world application of Delta hedging.
Key Words: Options, Option Pricing Model, Portfolio, Underlying Security, Delta hedging
Introduction
Over the past few decades, the performance of financial markets has been significantly improved by the development of new technologies in the information processing. The creation of new types of derivative based structured financial instruments has added new dimensions and perspectives to the capital markets and investment management function. Conceptual advances have allowed various financial institutions to create derivative based financial instruments, value them and hedge the complex portfolios. Financial institutions have been selling structured options to their clients in the over-the-counter market. They are faced with the problem of managing the risks associated with such products, as they are non-standard financial instruments tailored to the specific needs of a client. Also, it is important
1
Practical Considerations in the Application of Delta Neutral Hedging
Paper Reference No: A553
T.V.Venkatarathna, Senior Consultant, Polaris Software Lab Limited,
Survey No.203/Part, Manikonda IT Park,
Hyderabad 500 019 venkat.tv@polaris.co.in Many financial institutions hold derivative instruments in their portfolio whose value changes in response to a change in the value of the underlying security. The option-pricing model developed by Black and Scholes (1973) indicates that a portfolio consisting of a risky asset and call options thereon can be balanced in such a way that the returns from the portfolio will approximate to a risk free rate of return. Ascertaining the right balancing mix between the units of the underlying security and the options thereon is the central theme of Delta hedging. This paper summarizes the guiding principles to design a Delta neutral portfolio and examines the practical considerations involved in the real world application of Delta hedging.
Key Words: Options, Option Pricing Model, Portfolio, Underlying Security, Delta hedging
Introduction
Over the past few decades, the performance of financial markets has been significantly improved by the development of new technologies in the information processing. The creation of new types of derivative based structured financial instruments has added new dimensions and perspectives to the capital markets and investment management function. Conceptual advances have allowed various financial institutions to create derivative based financial instruments, value them and hedge the complex portfolios. Financial institutions have been selling structured options to their clients in the over-the-counter market. They are faced with the problem of managing the risks associated with such products, as they are non-standard financial instruments tailored to the specific needs of a client. Also, it is important
References: 1. Issues in Hedging Options Positions by Nandi, Saikat; Waggoner, Daniel F. Economic Review (Federal Reserve Bank of Atlanta), 2000 1st Quarter, Vol 4. Alternative paths to portfolio insurance by Rubinstein, Mark (1985) – Financial Analysis Journal, 41 (4), 42-52. Fourth AIMS International Conference on Management December 28-31, 2006 10 Fourth AIMS International Conference on Management December 28-31, 2006 11