In other words, it can also be said that delta hedging is a plan that is adopted by the derivative dealers in order to reduce the exposure of the portfolio to certain underlying instruments. The derivative dealer first determines the delta of the portfolio with respect to the underlying security and then turns the delta of the portfolio to zero by adding an offsetting position in the underlying security.
The following example can explain the process. Let us assume that a derivative dealer sells a gold call option and a negative gold delta of 5000 ounces is resulted. The dealer then buys a gold spot of 5000 ounces in order to lessen the exposure of the portfolio.
When taken together, the long gold and short option show a combined zero gold delta. The delta hedging can also be called as the strategy that is taken up by the option granters in order to protect the portfolio exposure.
The derivative delta is used to hedge or eliminate a derivative holding with underlying security position or vice-versa. The number of underlying security units that is required to hedge a derivative is same as the delta of derivative. The concept of delta hedging is implemented in order to cover the positions of trading and also to arbitrage the difference between the costs required for the purchasing of adequate amount of underlying and the cost of derivative. Since the value of delta changes according to the underlying price, the delta hedge also must be adjusted continuously. If the hedge is reversed and is combined with the debt or cash, the derivative cash flows can be replicated. According to the one price law, the derivative value has to be same as the portfolio value of the one that replicates it.
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Last Updated on : 1st July 2013