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- The value of an option is sensitive to the changes in factors such as interest rates, value of underlying asset, volatility and time to expiration. An option trader holds different option positions and any adverse movement in the factors affects the options value resulting in a bad impact on his positions.
- A risk manager also has positions which he needs to monitor carefully and adjust to meet the risk requirements of the company. Therefore, any change in the sources of risks underlying the derivative gets translated in the value of the derivative. This necessitates the management of different risks derived from the option portfolios.
- Delta measures the • change in the option's price due to a change in the price of the underlying asset. The prices of most of the underlying assets are affected to a great extent due to changes in interest rates. Delta hedge relates to managing the portfolio such that it is not affected adversely due to movements in interest rates.
- The main drawback of delta hedging is that it requires continuous re-balancing.
- Gamma can be defined as the rate of change of a derivative's delta with respect to a change in the price of the underlying asset or derivative. Gamma hedging is a hedge position in which the changes in delta will be unaffected by large movements of the underlying asset. It is usually combined with delta hedge.
- Vega hedge portfolio is one in which the portfolio value will not change in the volatility of the underlying source of risk.
- A portfolio manager may reduce his losses by insuring his portfolio. This is done by buying put options on the stock index in addition to the stock. Else, one can create put options synthetically. This strategy is known as portfolio insurance or dynamic hedging.