(Merrill Lynch)

From a theoretical point of view, theta is a relatively simple quantity: the rate of change in value of a financial derivative with respect to time. In a Black-Scholes world, the theta of a delta hedged option can be viewed as `rent’ paid in exchange for gamma. This relationship is fundamental to the risk-management of a derivatives portfolio. However, in the real world, the situation becomes significantly more complicated. In practice the model is continually being recalibrated, and whereas in the Black-Scholes world volatility is not a risk factor, in the real world it is stochastic and carries an associated risk premium. With the heightened interest in automation and electronic trading, we increasingly need to attempt to capture trading, marking and risk management practice algorithmically, and this requires careful consideration of the relationship between the risk neutral and historical measures. In particular these effects need to be incorporated in order to make sense of theta and the time evolution of a derivatives portfolio in the historical measure.