Reading 39: Risk Management App....tion Strategies－LOS e gamma, which

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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 e: Identify the conditions in which a delta-hedged portfolio is affected by the second-order gamma effect.

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In delta-hedging, gamma would be important if the price of the underlying asset:

A) had a large move upward only.

B) had a large move upward or downward.

C) had a large move downward only.

D) remained constant.

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Answer and Explanation

Gamma refers to the change in value of delta given the change in value of the underlying stock. Typically, larger swings in the price of an asset will cause larger changes in delta, thus impacting the delta hedge. This means that the larger the move in the underlying asset in either direction, the more important is the second-order gamma effect.

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In delta-hedging a call position, which of the following pairs of conditions would lead to the gamma effect being the most important? The call is:

A) at-the-money and near expiration.

B) out-of-the-money and near expiration.

C) at-the-money and has a long time until expiration.

D) out-of-the-money and has a long time until expiration.

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Answer and Explanation

Gamma refers to the change in value of the delta given the change in value of the underlying stock. Gamma will be most important when the call option being hedged is either at the money or near expiration.

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All of the following are conditions that make the second-order gamma effect more important to a manager delta-hedging an option EXCEPT when the:

A) delta is near zero.

B) option is near expiration.

C) option is at-the-money.

D) underlying asset is volatile.

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Answer and Explanation

All of these conditions make the gamma effect more important except the delta being near zero. If the delta is near zero or one then the option delta will move more slowly towards zero or one and cause less of an affect on gamma.