Module 40.7 LOS 40.m: Role of Gamma Risk in the BSM model

The BSM model predicts that changes in stock price is happens continuously, not abruptly. If this were the case, there would be no gamma risk, however, gamma risk can be viewed as a measure of stock price jumps. A jump in price would cause a delta-hedged portfolio unhedged. The official measure of the gamma risk how poorly a dynamic hedge would perform if it is not rebalanced after a change in asset price.

If we consider the case of a long stock position and a short call potion, an abrupt fall in price will cause the loss from the stock position to outweigh the gains from the short call. The stock has a delta of one, and gamma will be zero, so gamma exposure will be negative. This is the gamma risk of the hedge.

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