Hedging Rho Exposure in Primary Option Position with Interest-Rate Options

Abstract

This thesis explores the growing concern of rho exposure that market-makers need to address in their options portfolio due to the volatility of interest rates. Primarily, we look at S&P 500’s at-the-money options to understand why sensitivity to interest rates has increased over time, and whether the dependency on rates can be hedged. We theorize that rho has increased over time for options due to the market’s movement to a different area along the volatility surface. Then, we analyze SOFR contracts and find that variance of a portfolio is minimized with the existence of an interest rate derivative. At a closer look, we look at an at-the-money option from July 2022 when interest rates were volatile, and we notice that the P/L of the portfolio that consists the SOFR instrument is significantly higher. Therefore, suggesting that specialized instruments can be used to hedge some of the rho exposure in a portfolio.