Chapter 16
Financial
Engineering and
Risk Management
1
© 2004 South-Western Publishing
Outline
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2
Introduction and background
Financial engineering
Risk management
Introduction and Background

Financial engineering:
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3
Is a relatively new derivatives endeavor
Has led directly to improvements in the process
of risk management
Introduction and Background
(cont’d)

Risk management awareness is associated
with various phrases:
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–
–
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4
Asian flu
Global contagion
Orange County
“We take the risks because of the potential
reward”
Financial Engineering
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5
Synthetic put
Engineering an option
Gamma risk
Synthetic Put
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
Financial engineering is the popular name
for constructing asset portfolios that have
precise technical characteristics
In the early days of the CBOE there were no
puts; only calls traded
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6
Can construct a put by combining a short
position in the underlying asset with a long call
Synthetic puts were the first widespread use of
financial engineering
Synthetic Put (cont’d)
+
short stock
7
+
=
long call
=
long put
Engineering an Option

There are a variety of tactics by which
wealth can be protected without disturbing
the underlying portfolio
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8
Shorting futures provides downside protection
but precludes gains from price appreciation
Writing a call provides only limited downside
protection
Buying a put may be the best alternative
Engineering an Option (cont’d)
Strategy
9
Advantages
Disadvantages
Short futures Low trading fees;
Easy to do
Lose upside potential;
Possible tracking error
Write calls
Generate income
Lose most upside potential;
Inconvenience if exercised;
Limited protection
Buy puts
Reliable
protection
Premium must be paid;
Hedge may require periodic adjustment
Engineering an Option (cont’d)

Extensive purchase of individual equity
puts is inefficient in a large portfolio
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10
Portfolio may contain dozens of stocks,
resulting in numerous trading fees, managerial
time, and high premium cost
Index options or futures options are best suited
Engineering an Option (cont’d)
Financial Engineering Example
Assume that T-bills yield 8% and market volatility is 15%. Black’s
options pricing model predicts the theoretical variables for a 2-year
XPS futures put option with a 325.00 striking price as follows:
Striking price = 325.00
Index level = 326.00
Option premium = $23.15
Delta = -0.388
Theta = -0.011
Gamma = 0.016
Vega = 1.566
11
Engineering an Option (cont’d)
Financial Engineering Example
Linear programming models can be utilized to obtain the
desired theoretical values from existing call and put options.
The greater the range of striking prices and expirations from
which to choose, the easier the task.
12
Engineering an Option (cont’d)
Financial Engineering Example
13
Available XPS
Linear
Options
Programming
Synthetic Put
With Desired
Theoretical Values
Engineering an Option (cont’d)

The tough part of engineering an option is
dealing with the dynamic nature of the
product
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To keep the engineered put behaving like a
“real” one, it is necessary to adjust the option
positions that comprise it (dynamic hedging)
How frequently you should reconstruct the
portfolio to fine-tune delta depends on the rest
of your market positions and the magnitude of
the trading fees you pay
Engineering an Option (cont’d)
Primes and Scores
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
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15
PRIME is the acronym for “Prescribed Right to Income and
Maximum Equity”
SCORE stands for “Special Claim on Residual Equity”
PRIMEs and SCOREs were arguable the first of the
engineered hybrid securities
Securities provided investors a means of separating a stock’s
income and capital appreciation potential
Engineering an Option (cont’d)
Primes and Scores (cont’d)
Americus Trust
Unit
16
PRIME
SCORE
Common
Stock
Gamma Risk

There are several ways to engineer
derivatives products that differ with regard
to their cost and their robustness

Gamma risk measures:
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How sensitive the position is to changes in the
underlying asset price
The consequences of a big price change
Gamma Risk (cont’d)
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An options portfolio with a gamma far from
zero will rattle apart when the market
experiences stormy weather
Gamma Risk (cont’d)
Gamma Risk Example
Suppose we hold 10,000 shares of a $60 stock and want to
temporarily move to a position delta of zero.
19
Gamma Risk (cont’d)
Gamma Risk Example (cont’d)
Options Data
Calls
20
Strike
Premium
50
$11.24
60
70
Delta
Puts
Gamma
Premium
Delta
Gamma
0.880
0.019
$0.63
-0.121
0.019
$4.51
0.565
0.037
$3.84
-0.445
0.038
$1.31
0.244
0.029
$10.71
-0.787
0.033
Gamma Risk (cont’d)
Gamma Risk Example (cont’d)
Alternative Solution A
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Position
Quantity
Delta
Gamma
Premium
Stock
+10,000
+10,000
-
-
60 Call
-100
-5,650
-370
+$45,100
60 Put
+98
-4,361
+372
-$37,632
-11
+2
+$7,468
Gamma Risk (cont’d)
Gamma Risk Example (cont’d)
Alternative Solution B
Position
Quantity
Delta
Gamma
Premium
Stock
+10,000
+10,000
-
-
-114
-10,032
-217
+$128,136
-32
-217
+$128,136
50 Call
22
Gamma Risk (cont’d)
Gamma Risk Example (cont’d)

Both solutions have an initial position delta close to zero
Solution B has the attraction of bringing in a great deal more
than Solution A
Solution B’s negative gamma may be hurt by a fast market

Assume the underlying stock price rises by 5% to $63
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23
Gamma Risk (cont’d)
Gamma Risk Example (cont’d)
Options Data
Calls
24
Strike
Premium
50
$13.96
60
70
Delta
Puts
Gamma
Premium
Delta
Gamma
0.927
0.012
$0.36
-0.074
0.013
$6.38
0.668
0.032
$2.68
-0.339
0.033
$2.14
0.336
0.033
$8.47
-0.687
0.035
Gamma Risk (cont’d)
Gamma Risk Example (cont’d)
Alternative Solution A: 5% Increase in Stock Price
Position
Quantity
New Delta
Change in
Option
Value
Gain or Loss
Stock
+10,000
+10,000
-
+$30,000
60 Call
-100
-6,680
+$1.87
-$18,700
60 Put
+98
-3,322
-$1.16
-$11,368
-2
25
+$68
Gamma Risk (cont’d)
Gamma Risk Example (cont’d)
Alternative Solution B: 5% Increase in Stock Price
Position
Quantity
New Delta
Change in
Option
Value
Gain or Loss
Stock
+10,000
+10,000
-
+$30,000
-114
-10,568
+$2.72
-$31,008
60 Call
-568
26
-$1,008
Gamma Risk (cont’d)
Gamma Risk Example (cont’d)
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Solution A is preferable because:
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Its position delta remains near the target figure of zero
Its value changed by only $68, while the other portfolio declined
by over $1,000
Risk Management
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Managing company risk
Managing market risk
Managing Company Risk

Many modern portfolio managers actively
practice some form of delta management
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Delta management refers to any investment
practice that monitors position delta and seeks
to maintain it within a certain range
Delta is a direct measure of the “degree of
bullishness” represented in a particular security
position or portfolio
Managing Company Risk
(cont’d)
Bullish
Out of the
Market
0%
+
-
+
Bearish
Position Delta
30
Fully
100% Invested
Managing Market Risk

Most institutional use of SPX futures is to
reduce risk rather than eliminate it
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If you completely eliminate risk, returns should
be modest
Managing Market Risk (cont’d)

Delta management of market risk involves
futures puts and calls
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A long futures contract has a delta of 1.0
Call options have deltas near 1.0 if they are
deep-in-the-money and near zero if they are far
out-of-the-money
Managing Market Risk (cont’d)

Delta management of market risk involves
futures puts and calls (cont’d)
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Puts have deltas near –1.0 when deep-in-themoney and near zero if far out-of-the-money
When the striking price is near the price of the
underlying asset, the option delta will be near
0.5 (for calls) or –0.5 (for puts)