Which of the following are true:

Which of the following are true:

I. Delta hedges need to be rebalanced frequently as deltas fluctuate with fluctuating prices.

II. Portfolio managers are right to focus on primary risks over secondary risks.

III. Increasing the hedge rebalance frequency reduces residual risks but increases transaction costs.

IV. Vega risk can be hedged using options.
A . I and II
B . II, III and IV
C . I, II, III and IV
D . I, II and III

View Answer

Answer: C

Explanation:

Delta is non-linear with respect to prices for a number of securities such as bonds, options and other derivatives. It changes with changes in prices, and any hedge initially undertaken becomes quickly mismatched. Therefore delta hedges need to be managed quite actively and kept up-to-date. Therefore I is true. Primary risks comprise most of the risk in a position, and therefore portfolio managers are right to focus on them over secondary risks. Therefore II is true. The greater the hedge rebalance frequency, the lower is the hedge mismatch at any point in time, and therefore residual risks would be lower. However, rebalancing hedges requires rebalance trades to be done, and these involve transaction costs. Generally, a reasonable balance needs to be struck between the frequency of

rebalances (a lower frequency increases residual risk, but this residual risk is not directionally biased) and the costs of rebalancing. III is correct. Vega risk is the risk arising due to changes in prices due to changes in volatility. Options carry vega risk. Therefore any hedges against vega risks can only be obtained using other options positions. (Vega risk may also be hedged using other volatility based products, eg an OTC volatility swap, or a VIX futures type product.)