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This episode aired on BloombergTV on Jun 25, 2012

The Greeks

“The Greeks” are several measures used to describe the relationship between a derivative contract and its underlying asset. These five measures- Delta, Gamma, Theta, Vega and Rho- all measure specfic aspects of the relationship between derivative and underlying. Delta is the sensitivity of the price of the derivative to changes in the price of the underlying. Gamma is the change in Delta as the price of the underlying changes. Theta measures the sensitivity of hte derivatives price to the passage of time. Vega, not technically a part of the Greek alphabet, measures the sensitivity of the derivative’s value to the volatility of the underlying. Finally, Rho measures the sensitivity of the derivative’s value to changes in interest rate.

Q. So we’re not talking here about the possibilities of a “Grexit” or reintroduction of the Drachma, huh? “Greeks” doesn’t mean “Greeks”? That sure qualifies it as a real buzzword!

A. Yes, all sorts of confusion is possible over this one. “The Greeks” refers to several measures of the way the price of a derivative relates to the price of an asset to which the derivative relates. For example, one that we’ve already talked about is Delta, and that’s the most important one: it refers to the relationship between the price of an underlying asset, and the price of an option or other derivative on that asset. Options and derivatives prices typically do not move dollar for dollar with the underlying asset; “delta” how much the derivative moves when the underlying asset price changes.

Q. Ok, but we’ve talked about other Greek letters before… alpha, beta, sigma… are they also called “Greeks”?

A. No, even though, of course, they are letters in the Greek alphabet. So that’s another point of confusion. But when you use the term “the Greeks”, you mean 5 specific measures of the sensitivity of a derivative to its underlying asset. So, aside from Delta, we have Theta–starts with T, for Time sensitivity; and Rho — starts with R for interest rate sensitivity. And then there’s one that’s sort of a cheat, Vega, which is sensitivity to volatility.

Q. And that’s a cheat because…

A. Because there’s no V in the Greek alphabet, so we have to use a Y instead. On the other hand, there’s so much volatility in Greece right now that it seems to fit anyway.

Q. Alright, just one to go. Are you saving the best for last?

A. Yes! Gamma. Now this is a good one because you’ll often hear about folks who are Gamma traders. So Gamma refers to the change in delta over time… that is, how much the derivative’s sensitivity to price actually changes. It’s a pretty tricky one, but there are in fact lots of Gamma traders out there. So, bottom line: when you hear a trader say he’s making money off the Greeks, don’t assume he means he’s speculating on the country’s departure from the Euro.