(News Bulletin 247) – The Greek alphabet is often used in financial terms to measure different parameters of an asset or a portfolio. Here is a fairly simple overview of the most famous letters in finance.

These are not letters that are very common in the economic and financial press. But many trading room specialists or finance students have already broken their teeth over it: the “Greeks”.

Several letters of the Greek alphabet are in fact used on the stock market to calculate certain parameters of a financial asset or a portfolio. Here are the main ones:

## >Alpha

You may have already heard the expression “generating alpha” in the stock market. This simply means creating outperformance compared to a given benchmark. Moreover, the name of the famous financial information service of Financial Times “Alphaville” is certainly linked to the financial meaning of the first letter of the Greek alphabet (on the other hand, it probably does not refer to the German new wave group from the 80s Alphaville).

Thus the “alpha” of a portfolio or an action is obtained by calculating the difference between the return of this portfolio or this action with that of a reference, such as for example a known index (CAC 40, S&P 500).

Let’s take a simplistic example: the increase in the Hermès share is 29.5% since the start of the year compared to 12% for the CAC 40. The alpha of the Hermès share is therefore 17.5%.

As IG.com explains, there are more complex calculations taking into account in particular the risk-free rate of return (for example the rate of 10-year French or German government debt).

## > Beta

The beta of a stock or portfolio measures how a stock or portfolio performs relative to a benchmark, again often a known index. We spare you its calculation, based on the covariance of the asset and the reference divided by the variance of the reference.

The important point is to understand that the higher a stock has a beta, the more its variation on the stock market tends to exceed that of a benchmark index. Conversely, a negative beta does not mean that the stock is “bad” but that it tends to move in the opposite direction to an index, which is for example the case of defensive stocks. It is therefore a measure of volatility.

“Stocks of a utility company, for example, will tend to be more resilient to market movements and, as such, will have a low beta coefficient. On the other hand, start-ups and corporations highly volatile technologies will often have a beta much greater than one,” explains IG.Com.

## Other letters and options

The next Greek letters apply to options, i.e. products derived from a given asset. A reminder is in order: an option gives the right (and not the obligation) to acquire or sell an underlying asset at a given price (the exercise price) during a certain period. Buying an option means acquiring this right for a price, called a “premium”.

Example: Buying a call (purchase option) on a share A with a strike price of 50 euros for a premium of 1 euro consists of paying 1 euro to play an increase in the stock. The investor will pocket a profit if the share price exceeds 51 euros (the exercise price to which the cost of the premium is added).

With the foundations laid, let’s move on to the next letters.

>Delta

Delta measures the variation in the premium of an option compared to that of the price of its underlying asset, such as a stock. For a call option, it is between 0 and 1. A delta of 1 means that the premium moves exactly the same as the underlying asset (when the price of the underlying asset increases by 5%, the premium increases by 5%). A delta of 0.5 means that if the asset grows by 5%, the premium only increases by 2.5% (5% x 0.5).

Example: a stock trading at 50 euros has a call option with a delta of 0.30 and which costs 1 euro. Suppose that the underlying stock rises to 55 euros (i.e. an increase of +10%), the option should then be worth 1.03 euros (i.e. 10% x 0.3 = +3%), given its delta.

The deltas of call options are positive while those of put options are logically negative (the more the value of the stock falls, the more that of the option increases, with a delta between -1 and 0).

>Gamma

We go up one floor in the rocket. Gamma measures the sensitivity of the option’s delta in relation to the price of the underlying. The delta of the delta in a way.

“To use an analogy often borrowed from physics, the delta corresponds to the speed of change in the price of an option (first derivative), and the gamma to its acceleration (second derivative),” explains CMC Markets.

>Theta

The adage goes that “time is money”. This is precisely what theta allows us to quantify. This Greek letter measures the loss in value of an option as its expiration approaches. Theta is always negative.

“A high theta indicates that the option is close to its expiration date, the closer the option is to its expiration date, the faster it will depreciate,” explains IG.com.

> Rho

This time the rho measures the sensitivity of an option in relation to the change in the risk-free rate. “If the variation in interest rates increases the price of the option, then rho is positive. If, on the contrary, this variation causes the price of the option to fall, then rho is negative,” underlines IG.com

If, for example, the 10-year yield rate on the German bond increases by 1% and the option has a rho of 3 and an initial premium of 100 euros, then its premium increases to 103 euros.

>Vega

The letter vega quantifies the sensitivity of the option price according to the evolution of volatility. It is important to understand that the more volatility increases, the more (normally) the options have value. Indeed, strong market movements increase the risk for a stock (or any other underlying) of deviating from the exercise price of the option and therefore allowing an investor to make a profit.

As the Corporate Finance Institute points out, vega is often expressed in dollars per point of volatility. So an option with a vega of \$0.1 means that for every one percentage point increase in volatility, the option premium increases by \$0.1.