Phase 15 - Lesson 15.1

Black–Scholes Assumptions, the Greeks, and Hedging

The pricing PDE as a hedging identity, the sensitivities that run a derivatives book, and where the model’s assumptions break.

⏱ 55 min● Advanced🔗 Prereqs: Phase 9 (Itô calculus, risk-neutral pricing)
↖ Phase 15 hub
Builds on: Phase 9 built Itô’s lemma, Girsanov, and the risk-neutral valuation of a European claim.
Leads to: 15.2 shows the single σ assumption fails across strikes, launching the smile.

Learning Objectives

Click a status chip to cycle: Not started → In progress → Studied → Practiced → Needs review → Mastered.

Key Vocabulary

Delta Δ
Sensitivity of the option value to the underlying, \(\partial V/\partial S\); the hedge ratio.
Gamma Γ
Curvature \(\partial^2 V/\partial S^2\); how fast delta moves, so how often you must re-hedge.
Vega ν
Sensitivity to volatility \(\partial V/\partial\sigma\); not a Greek letter, but the risk that dominates a smile.
Theta Θ
Time decay \(\partial V/\partial t\); the price you pay (or earn) for holding the position as time passes.
Rho ρ
Sensitivity to the interest rate \(\partial V/\partial r\); usually the smallest first-order risk.
Delta-hedging
Continuously holding \(-\Delta\) units of the underlying so the portfolio is instantaneously insensitive to \(S\).
Self-financing
A trading strategy whose value changes only through market moves, with no external cash injected or withdrawn.

Intuition & Motivation

Intuition
Black–Scholes is not really a formula - it is a hedging argument. If the stock follows a geometric Brownian motion with known volatility \(\sigma\), then an option can be replicated by continuously trading the stock and cash. Because the replicating portfolio has the same payoff as the option in every state, no-arbitrage forces them to have the same price today. The Greeks are simply the derivatives of that price: they tell you how many shares to hold (\(\Delta\)), how fast that number moves (\(\Gamma\)), and how the value bleeds with time (\(\Theta\)). A delta-hedged option is a bet on realized versus implied volatility, and the gamma–theta identity is exactly how that bet pays.

The assumptions - and a map of what fails

The classical model of Black, Scholes and Merton assumes the underlying solves, under the physical measure,

\[dS_t=\mu S_t\,dt+\sigma S_t\,dW_t,\qquad \sigma\ \text{constant},\] (15.1)

with a constant risk-free rate \(r\), no dividends, no transaction costs, continuous frictionless trading, and no arbitrage. Every model later in this phase relaxes exactly one of these:

AssumptionRealityModel that relaxes it
Constant σOptions at different strikes imply different σLocal vol (15.3), Stochastic vol (15.4)
Lognormal returnsFat tails, skew, jumpsLocal/stochastic vol, jump models
Continuous costless hedgingDiscrete hedges, bid–ask, impactTransaction-cost models (Phase 16)
Single flat surfaceA whole \(\sigma(K,T)\) surface tradesVolatility surface (15.5)

The pricing PDE as a hedging identity

Form a portfolio long one option \(V(S,t)\) and short \(\Delta\) shares: \(\Pi=V-\Delta S\). By Itô’s lemma,

\[d\Pi=\Big(\tfrac{\partial V}{\partial t}+\tfrac12\sigma^2S^2\tfrac{\partial^2 V}{\partial S^2}\Big)dt+\Big(\tfrac{\partial V}{\partial S}-\Delta\Big)dS.\] (15.2)

Choosing \(\Delta=\partial V/\partial S\) kills the random \(dS\) term. A riskless portfolio must earn \(r\,\Pi\,dt\), giving the Black–Scholes PDE:

\[\frac{\partial V}{\partial t}+\tfrac12\sigma^2 S^2\frac{\partial^2 V}{\partial S^2}+rS\frac{\partial V}{\partial S}-rV=0.\] (15.3)
Key Idea
The PDE says the same thing as the Greeks: \(\Theta+\tfrac12\sigma^2S^2\Gamma+rS\Delta-rV=0\). Time decay is exactly compensated by gamma (curvature) plus the carry on the hedge.

For a European call the solution is the Black–Scholes formula

\[C=S\,N(d_1)-Ke^{-rT}N(d_2),\quad d_{1,2}=\frac{\ln(S/K)+(r\pm\tfrac12\sigma^2)T}{\sigma\sqrt{T}},\] (15.4)

where \(N\) is the standard normal CDF. Put–call parity \(C-P=S-Ke^{-rT}\) then fixes the put.

The Greeks

Differentiating (15.4) gives the sensitivities that a trading desk manages in real time (\(n(\cdot)\) is the normal PDF):

GreekCall formulaSign / meaning
Δ\(N(d_1)\)in \([0,1]\); hedge ratio
Γ\(\dfrac{n(d_1)}{S\sigma\sqrt{T}}\)>0; peaks near ATM
Vega\(S\,n(d_1)\sqrt{T}\)>0; largest ATM, long-dated
Θ\(-\dfrac{S n(d_1)\sigma}{2\sqrt{T}}-rKe^{-rT}N(d_2)\)usually <0 for long options
ρ\(KTe^{-rT}N(d_2)\)>0 for a call
Worked Example - Delta-hedged P&L over one step: the gamma–theta trade-off
1
Hold one option and hedge with \(-\Delta\) shares. Over a small step the hedged P&L is \(\Theta\,dt+\tfrac12\Gamma\,(dS)^2\) (the delta term is hedged away).
2
Replace \((dS)^2\approx\sigma_{\text{real}}^2 S^2\,dt\) using the realized variance actually observed.
3
Substitute the PDE identity \(\Theta\approx-\tfrac12\sigma_{\text{imp}}^2S^2\Gamma\) (dropping carry): the hedged P&L is \(\tfrac12\Gamma S^2\big(\sigma_{\text{real}}^2-\sigma_{\text{imp}}^2\big)\,dt\).
4
Interpretation: a delta-hedged long option makes money exactly when realized vol exceeds the implied vol you paid. You are long gamma and short theta; the two net to a bet on variance.

Interactive: the Greeks explorer

Drag spot, strike, vol, rate and maturity and watch price and every Greek respond. Confirm the signs in the table above.

Interactive: price by Monte Carlo, check against the formula

The risk-neutral price is \(e^{-rT}\,\E^{\Q}[(S_T-K)^+]\). Simulate lognormal terminal prices and watch the Monte Carlo estimate converge to the closed-form value.

Interactive: implement the price and Greeks

Common Mistakes to Avoid
  • Confusing the physical drift \(\mu\) with the risk-neutral drift \(r\): pricing and hedging use \(r\), not \(\mu\).
  • Reporting vega ‘per 1%’ but coding it per unit vol (a factor of 100). Be explicit about units.
  • Believing delta-hedging removes all risk: it removes first-order \(S\) risk only; gamma, vega and jump risk remain.
  • Treating theta as pure loss - for a delta-hedged book theta is the premium you collect against gamma.
Quant Practitioner Tips
  • Manage a book by net Greeks, not position-by-position: aggregate delta/gamma/vega across all strikes and maturities.
  • Near expiry ATM options have exploding gamma and theta - hedging costs and pin risk spike; size accordingly.
  • Vega and gamma are largest ATM but at different maturities: gamma is a short-dated risk, vega a long-dated one.
  • Always sanity-check a pricer with put–call parity and limiting cases (deep ITM delta→1, \(\sigma\to0\) → intrinsic).

Knowledge Check

Q1 Medium
In the Black–Scholes derivation, delta-hedging removes the random term so that the portfolio must earn the risk-free rate. The economic content is that:
The option is riskless
The stock has zero drift
An option can be replicated, so no-arbitrage pins its price regardless of the stock’s real drift
Volatility does not affect the price
Q2 Medium
A trader is long a delta-hedged straddle. Over the next month realized volatility comes in far below the implied vol paid. The position:
Profits, because it is delta-hedged
Loses, because gamma P&L cannot offset the theta paid
Is unaffected by realized vol
Profits only if the stock rises
Q3 Easy
Which statement about the Greeks is correct?
Gamma and vega both peak deep in-the-money
Theta is always positive for a long call
Call delta lies in \([0,1]\) and equals \(N(d_1)\)
Rho is typically the largest first-order Greek

Practical Exercise

A dealer sells a one-year ATM call on a non-dividend stock (\(S=K=100\), \(r=5\%\)) at an implied vol of \(20\%\) and delta-hedges daily. (a) Explain in one paragraph what P&L this position earns and on what it depends. (b) If the stock actually realizes \(25\%\) volatility, does the dealer make or lose money, and why? (c) Name two real-world frictions that make the hedge imperfect.

▶ Show full solution

(a) Selling and delta-hedging a call makes the dealer short gamma / long theta. Each day the dealer collects the option’s theta but must pay the gamma cost of re-hedging when the stock moves. The net hedged P&L is approximately \(\tfrac12\Gamma S^2(\sigma_{\text{imp}}^2-\sigma_{\text{real}}^2)\,dt\) summed over the life of the trade (sign flipped because the dealer is short the option). It depends on realized vol versus the \(20\%\) implied sold.

(b) With realized \(25\% \gt 20\%\) implied, the term \(\sigma_{\text{imp}}^2-\sigma_{\text{real}}^2\) is negative, so the short-option dealer loses money: re-hedging costs (buying high, selling low as the stock whips around) exceed the theta collected. The dealer sold vol too cheaply.

(c) Frictions: (i) discrete rather than continuous hedging leaves residual gamma risk between rebalances; (ii) transaction costs / bid–ask spread on each re-hedge; also gaps/jumps and the fact that a single constant \(\sigma\) cannot describe the true dynamics.

After the reveal, answer for yourself: Would hedging more frequently always help the short-gamma dealer? What does it trade off?

Lesson Summary

Black–Scholes is a replication argument: delta-hedging a claim under geometric Brownian motion produces a riskless portfolio, yielding the pricing PDE and formula in which the physical drift disappears. The Greeks are the derivatives of that price and are what a desk actually manages; the PDE is equivalent to the gamma–theta identity, so a delta-hedged option is a bet on realized versus implied volatility. Every assumption - above all constant σ - is relaxed by the models that follow.

Formula Sheet Additions

Black–Scholes PDE
\[\frac{\partial V}{\partial t}+\tfrac12\sigma^2S^2\frac{\partial^2V}{\partial S^2}+rS\frac{\partial V}{\partial S}-rV=0\]
Equivalently the gamma–theta identity that a delta-hedged book earns.
Hedged P&L
\[\tfrac12\,\Gamma\,S^2\big(\sigma_{\text{real}}^2-\sigma_{\text{imp}}^2\big)\,dt\]
A delta-hedged long option is a bet on realized minus implied variance.
Error Log Checklist
  • Did I use \(r\) (not \(\mu\)) in the pricing and hedging?
  • Are my vega/theta units stated (per unit vol? per day?)
  • Did I verify put–call parity and the ATM limiting cases?
  • Did I account for gamma/vega risk that delta-hedging leaves behind?

Retrieval Practice

Close the lesson and answer from memory before checking. This is deliberate, effortful recall - the single highest-yield study action.

▶ Show retrieval prompts & answers
Q: Why does the physical drift \(\mu\) not appear in the option price?
A: Because the option is replicated by a self-financing stock+cash portfolio; no-arbitrage prices the replica, and the hedge cancels the \(dS\) term, leaving only \(r\) and \(\sigma\).
Q: What P&L does a delta-hedged long option earn, and on what does its sign depend?
A: Approximately \(\tfrac12\Gamma S^2(\sigma_{real}^2-\sigma_{imp}^2)dt\): positive when realized vol exceeds the implied vol paid, negative otherwise.
Q: Where do gamma and vega each peak, and how do their maturities differ?
A: Both peak near at-the-money; gamma is a short-dated risk (blows up near expiry) while vega is a long-dated risk (grows with \(\sqrt{T}\)).

Flashcards

Click to flip. These feed the site-wide spaced-repetition queue.

Black–Scholes PDE
\(\Theta+\tfrac12\sigma^2S^2\Gamma+rS\Delta-rV=0\); a delta-hedged portfolio earns the risk-free rate.
Call Greeks
\(\Delta=N(d_1)\), \(\Gamma=n(d_1)/(S\sigma\sqrt{T})\), vega \(=S n(d_1)\sqrt{T}\); gamma/vega peak ATM.
Gamma–theta trade-off
Delta-hedged option P&L \(\approx\tfrac12\Gamma S^2(\sigma_{real}^2-\sigma_{imp}^2)dt\): a bet on realized vs implied vol.

Completion Checklist

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Source References

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