Question

Use the following case in answering Problems 10 – 15 : Mark Washington, CFA, is ananalyst with BIC. One year ago, BIC analysts predicted that the U.S. equity market wouldmost likely experience a slight downturn and suggested delta-hedging the BIC portfolio.

As predicted, the U.S. equity markets did indeed experience a downturn of approximately4% over a 12-month period. However, portfolio performance for BIC was disappointing,lagging its peer group by nearly 10%. Washington has been told to review the optionsstrategy to determine why the hedged portfolio did not perform as expected.

After discussing the concept of a delta-neutral portfolio, Washington determines that heneeds to further explain the concept of delta. Washington draws the value of an optionas a function of the underlying stock price. Draw such a diagram, and indicate how deltais interpreted. Delta is the:

a. Slope in the option price diagram.

b. Curvature of the option price graph.

c. Level in the option price diagram.

Short answer

Option a.

Step-by-step solution

Definition of delta

The change in the option price for an instant change in the stock price is known as a delta.

Validation of deltainterpretation 

On the graph, this change is equal to the slope of the option price diagram

Therefore the correct option is ‘a’.

Option b is incorrect as the slope will be a straight line as the change of stock price and option are towards same direction.

Option c is incorrect as delta shows variation in price of option at $1 for stock price. So this is not a condition in diagram.