Enterprise Risk Management In Black Scholes Option Pricing Model Using Risk Hedging Techniques

Abstract

Risk is the uncertainty associated with future outcome or event. Option traders face a risk of incurring losses as a result of unfavorable changes of parameters in the option pricing model. Options are financial derivatives which derive their value from underlying assets. Options became popular in 1973 after Fisher Black, Myron Scholes and Robert developed the Black Scholes option pricing model. Risk factors called Greeks are derived from this model. Greeks measure the sensitivity of the value of option to the changes in parameter values in the model holding other parameters fixed. These Greeks include: Delta, Gamma, Rho, Theta and Vega.Enterprise risk management (ERM) manages risks to be within the organization’s risk appetite. ERM deals with risks in holistic basis.Developing an ERM framework on option portfolios will help in risk management during option trading.Risk hedging techniques form a large part of ERM framework.These techniques include:Delta hedging, Gamma hedging, Vega hedging and Theta hedging. Keywords: Risk, Option, Enterprise Risk Management (ERM), Greek, Delta, Gamma, Vega, Theta, Rho, Hedging, derivative.