Deck 16: Dynamic Hedging and Relative Value Trades

Question 1

Given the Fundamental PDE, explain the theta-gamma relation.

Answer 1

The intuition for the Theta-Gamma relation is that a positive-value port- folio with a high Theta is expected to make money because of the passage of time. If it was to make more money than the risk free rate, it would be pure arbitrage, because a trader could borrow at the risk free rate, set up the portfolio, and wait. The negative convexity rebalances the pure arbitrage: the volatility in interest rates tends in average to depress the portfolio value.

Question 2

What is theta?

Answer 2

Theta is the capital gain (loss) on a bond due to the passage of time:

Question 3

What instrument is used to hedge derivative exposure?

Answer 3

For hedging derivatives on an underlying asset, we use the underlying asset itself.

Question 4

How close should the value of the Replicating Portfolio be to the asset if we increase the rebalancing frequency?

Question 5

Can you think of any reason why rebalancing doesn't always occur at extermely short frequencies (instantenous) in the real world?

Question 6

What is a Replicating Portfolio?

Question 7

What use does the Replicating Portfolio have?

Question 8

What means to rebalance the Replicating Portfolio?

Question 9

What general principal do you follow, once an arbitrage opportunity is found?

Question 10

What is a relative value trade?

Question 11

What is gamma?

Question 12

What is the theta-gamma relation?

Question 13

What steps do we follow for a relative value trade?