Reading 39: Risk Management App....tion Strategies－LOS d option, dealer, position, maintain, delta

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CFA Institute Area 8-11, 13: Asset Valuation
Session 13: Risk Management Applications of Derivatives
Reading 39: Risk Management Applications of Option Strategies
LOS d: Explain why and how a dealer delta hedges an option portfolio, why the protfolio delta changes, and how the dealer adjusts the position to maintain the hedge.

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A short position in naked calls on an asset can be delta hedged by:

A) buying the put.

B) shorting the underlying asset.

C) buying the underlying asset.

D) short naked calls cannot be delta hedged.

Answer and Explanation

Delta hedging a naked call can be accomplished by owning the underlying asset in an amount that will make the value of the short-call/long-asset portfolio immune to changes in the price of the underlying asset.

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A manager would delta hedge a position to:

A) earn the risk-free rate.

B) earn extra dividend income on a given position.

C) place a floor on the position while leaving the potential for upside risk.

D) effectively close the position and not monitor it anymore.

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Answer and Explanation

A delta hedged position should earn the risk-free rate. The position does not earn a dividend although it should increase in value gradually (at the risk-free rate). The upside potential is limited to the risk-free rate. The manager would have to constantly monitor and adjust the position to achieve the goal.

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An option dealer is delta hedging a short call position on a stock. As the stock price increases, in order to maintain the hedge, the dealer would most likely have to:

A) buy more shares of the stock.

B) sell some the shares of the stock.

C) buy T-bills.

D) short T-bills.

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Answer and Explanation

As the value of the underlying increases, the delta of a call option increases. This means more of the underlying asset is needed to hedge the position.