Risk Management in Trading: Techniques to Drive Profitability of Hedge Funds and Trading Desks

CHAPTER 8 Options, Greeks, and Non-Linear Risks

This chapter discusses how the risks of complex financial instruments are modeled. Certain types of financial instruments, like options, present much more complicated risk management challenges than simpler financial instruments like stocks and bonds. Risk managers have developed a variety of techniques to model this risk and fit it into the position limit (value-at-risk) framework used for other financial instruments. The most common technique used to monitor option risk is to break the option into several risk factors. These risk factors are named after Greek letters (and collectively called Greeks).

The option pricing formulas and Greeks described in this chapter are used by traders to control risk. By reducing complex financial instruments to a handful of exposures, options portfolios can be concisely described to senior management. This also allows position limits, like value-at-risk, to be applied to options. In practice, option portfolios often have a value-at-risk limit as well as a limit on each of their Greeks.

OPTIONS

Options are financial derivatives that give their owner the right, but not the obligation, to take some action at a predetermined point in the future. The ability to make a decision complicates the valuation of options. However, this also makes option pricing a flexible way to look at a wide variety of financial contracts. As a result, options can be both traded and found embedded in larger contracts. ...