LOS d: Explain why and how a dealer delta hedges an option portfolio, why the portfolio delta changes, and how the dealer adjusts the position to maintain the hedge.

Q1. 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 T-bills.

B)   buy more shares of the stock.

C)   sell some the shares of the stock.

Q2. A manager would delta hedge a position to:

A)   earn extra “dividend” income on a given position.

B)   earn the risk-free rate.

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

Q3. A short position in naked calls on an asset can be delta hedged by:

A)   shorting the underlying asset.

B)   buying the put.

C)   buying the underlying asset.

LOS d: Explain why and how a dealer delta hedges an option portfolio, why the portfolio delta changes, and how the dealer adjusts the position to maintain the hedge. fficeffice" />

Q1. 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 T-bills.

B)   buy more shares of the stock.

C)   sell some the shares of the stock.

Correct answer is B)

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.

Q2. A manager would delta hedge a position to:

A)   earn extra “dividend” income on a given position.

B)   earn the risk-free rate.

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

Correct answer is B)

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.

Q3. A short position in naked calls on an asset can be delta hedged by:

A)   shorting the underlying asset.

B)   buying the put.

C)   buying the underlying asset.

Correct answer is C)

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.

Thx!