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MFE Study Guide (Fall 2007)

Notes from McDonalds Derivative Markets


Written by Colby Schaeffer

MFE Study Guide

Fall 2007 2nd Edition

Introduction The material in this quick study guide has been done to the best of my knowledge. Some topics are only covered briefly (Delta-Hedging and Caps/Floors) while other topics have been omitted (Equity Linked Annuities and Compound Options w/One Discrete Dividend). All exam tips are marked in red! This the 1st Edition of my MFE study guide, and it may be updated in the future with better content. Comments and questions may be directed via PM to colby2152 on the Actuarial Outpost. 2nd Edition Notes: Jraven and fractl helped me tweak some little errors in the study guide. An entirely revamped Spring 08 Edition will be out by March 2008 with more on Brownian Motion, a better understanding but less detailed look at the Greeks, an easier view of convexity, and perpetual options will be removed. Acknowledgements: Day Yi, Abraham Weishus, Bill Cross and AO Member Jraven

Written by Colby Schaeffer

2/17

MFE Study Guide

Fall 2007 2nd Edition

Chapter 9 - Parity and Other Option Relationships Option Exercise Style American: any time European: end of maturity Value of otherwise identical options: European < American Put-Call Parity General Formula: Call(K, T) Put(K, T) = PV(FO,T K) K: strike price T: exercise time Put-Call parity usually fails for American-style options. Currency: C(K, T) P(K, T) = x0e-rT Ke-rT Stock: C(K, T) P(K, T) = S0 PV0,T(DIV) e-rTK Bond: C(K, T) P(K, T) = B0 PV0,T(Coupons) e-rTK Different Assets: C(St, Qt, T t) P(St, Qt, T t) = PV[Ft,T(S) - Ft,T(Q)] x0: current exchange rate denominated as $/ r: euro-denominated interest rate r: American or implied interest rate DIV: stream of dividends paid on stock Early Exercise for American Options American-style call options on a nondividend-paying stock should never be exercised prior to expiration. Early exercise is not optimal if: C(St, K, T t) > St K When exercising calls just prior to a dividend, early exercise is not optimal at any time where: K - PVt,T(K) > PVt,T(DIV) Arbitrage Inequalities (for both American & European) THERE IS NO FREE LUNCH! K1 < K2 < K3 0 C(K1) C(K2) K2 K1 0 P(K2) P(K1) K2 K1 *if options are European, then the difference in option premiums must be less than the present value of the difference in strikes

Premiums decline at a decreasing rate as we consider calls with progressively higher strike prices. Premiums also decline for puts but when the strike price monotonically decreases.

Written by Colby Schaeffer

3/17

MFE Study Guide

Fall 2007 2nd Edition

Convexity of option price w.r.t. strike price [C(K3) - C(K2)]/(K3 - K2) < [C(K2) - C(K1)]/(K2 - K1) [P(K2) P(K1)]/(K2 K1) [P(K3) P(K2)]/(K3 K2) Option Trends American options become more valuable as time to expiration increases, but the value of European options may go up or down. As the strike price increases for calls or decreases for puts, the options become less valuable with their price decreasing at a decreasing rate. With dividends, longer term European options may be less valuable than shorter term European options.

Written by Colby Schaeffer

4/17

MFE Study Guide

Fall 2007 2nd Edition

Chapters 10, 11 - Binomial Pricing assumes that the stock price can change to either an upper value or to a lower value

If the observed option price differs from its theoretical price, arbitrage is possible u e(r )h d
: delta, the number of shares to replicate the option payoff : dividend rate : volatility, the standard deviation of the rate of return on stock At the prices Sh = Su, Sd, a replicating portfolio will satisfy: ( Su eh ) + (B erh) = Cu ( Sd eh ) + (B erh) = Cd Risk Neutral Probability (of increase in stock)

p* =

e( r ) h d ud
h h

u = e( r ) h+ d = e( r ) h

Suppose that the continuously compounded expected return on the stock is and that the stock does not pay dividends, then the true probability of an up move is: P = (e(

)h

d) / (u d)

Multiple periods: work with future values and compute option prices retrospectively *Take step-by-step answers to six digits!

C / P = ert E[C / Pbinomial (value)]


American Options For an American call, the value of the option at a node is given by Written by Colby Schaeffer 5/17

MFE Study Guide

Fall 2007 2nd Edition

Call Value = max[S K *, erh(p* Value(Up) + (1 - p*)Value(Down)] *switch to K S for puts The valuation of American options proceeds as follows: At each node, we check for early exercise. If the value of the option is greater when exercised, we assign that value to the node. Otherwise, we assign the value of the option unexercised. Early Exercise: receive dividends, advance payment of strike (interest), and lose insurance Kr > St Call goes down Put goes up Kr < St Call goes up Put goes down Pricing Options on Other Assets Stock Index similar to nondividend-paying stocks Currency replace stock price with currency exchange rate and dividend rate with foreign risk-free rate:

Commodities replace dividend rate with lease rate Bonds volatility decreases over time and interest rates are variable Forwards forwards arent risk-free h

u=e

( r r f ) h + h

u=e

Stocks Paying Discrete Dividends The dividend is taken off the first node. The tree does not completely recombine after a discrete dividend unless it is a percentage of the stock. Another solution is to use: Schroders Method F = S PV(Div)

F = S

S F

Alternative Trees Cox Ross-Rubinstein

u = e

h h

d = e

Lognormal

Written by Colby Schaeffer

6/17

MFE Study Guide

Fall 2007 2nd Edition

u = e (r 0.5

2 )+ h 2 ) h

d = e (r 0.5

McDonald Assumes S = Sud

Written by Colby Schaeffer

7/17

MFE Study Guide

Fall 2007 2nd Edition

Chapter 12 Black-Scholes model The Black-Scholes formula is a limiting case of the binomial formula for the price of a European option.

d1 =

ln(Se t / Ke rt ) + 0.5 2 t

d2 = d1 t
Contrary to other forms of the d1 equation that you will see, this is the only one that you need to know. Currency and Futures options replace variables of this equation, but it remains the same.

C = Se tN(d1 ) KertN(d2 ) P = KertN(d2 ) Se tN(d1 )


Where N(x) is the cumulative normal distribution function Assumptions/Properties returns on stock are normally distributed and independent over time volatility and risk-free rate are both known and constant future dividends are known there are no transaction costs/taxes Currency Options Replace stock price with currency exchange rate and the dividend rate with foreign risk-free rate known as Garman-Kohlhagen model Futures Replace stock price with forward price and the dividend rate with risk-free rate. Option Greeks Formulas that express the change in the option price when an input to the formula changes, taking all other inputs as fixed. , delta: option price change w.r.t stock price change Delta is the only Greek that you are expected to compute call = e-t N(d1) put = -e-t N(-d1) call = put + e-t *Delta of a stock is always equal to 1 , gamma: measures convexity OR change in delta, always > 0 Vega: tests if volatility is sufficient, always > 0 Written by Colby Schaeffer 8/17

MFE Study Guide

Fall 2007 2nd Edition

, theta: option price change w.r.t. time to maturity change, usually < 0 , rho: sensitivity to risk free rate , psi: sensitivity to the dividend rate

The Greek measure of a portfolio is the sum of the Greeks of the individual portfolio components
Elasticity tells us the risk of the option relative to the stock in %terms S = C For a call 1, while for a put 0 option = stock | | Risk Premium: r = ( r) r Sharpe Ratio:

Perpetual Options 2 x 2 + 2(r 0.5 2 )x 2r = 0 Each x value is the present value of 1 when a stock of value S rises or falls to price H, where the value is (S/H)x h1 = lower value of x, and h2 = higher value of x Calls
h1

S Value: (H K ) H

h Maximum H: H * = K 1 h1 1
Puts just change (H K) to (K H) and change h1 to h2

Written by Colby Schaeffer

9/17

MFE Study Guide

Fall 2007 2nd Edition

Chapter 13 Delta Hedging Market makers want stable portfolios, so they use delta hedging as a method of controlling risk. Overnight Profit OP = C 0 C 1 + (S1 S 0 ) (e r / 365 1)(S 0 C 0 ) Delta-Gamma-Theta Approximation *Delta and Delta-Gamma approximations are contained within the formula 1 C (S t + h ) = C (S t ) + + 2 + h 2 Where: = S t +h S t Black-Scholes equation This is different than the Black-Scholes FORMULA that was used for pricing options. Rather, this equation is a function of the greeks, stock price, volatility, and risk-free rate.

1 2 2 S + rS + 2 1 Var (Rh ,i ) = (S 22h )2 2

rC (S ) =

Written by Colby Schaeffer

10/17

MFE Study Guide Chapter 14 Exotic Options

Fall 2007 2nd Edition

Asian Options based on the arithmetic/geometric average of underlying asset/strike price *useful for hedging currency exchange, variable annuities, and reducing volatility Geometric(S) < Arithmetic(S) Barrier Options payoff depends if price of asset reaches a barrier level payoff and option premium is less valuable than those of standard options 1. Knock Out option goes out of existence if price reaches barrier 2. Knock In option comes into play if price reaches barrier 3. Rebate fixed payment if asset price reaches barrier Knock-In + Knock-Out = Standard Option Compound Option option whose underlying asset is another option that expires later Compound Option Parity x: strike price of compound option t1: expiry of compound option t2: expiry of underlying option CallOnOption PutOnOption = Option xert1 Gap Options option with trigger K2 (price that option must be exercised) and strike price K1 that differ, election is not optimal Use K1 for put-call parity Exchange Options lets you receive an asset in exchange for another at time T, pays off only if the option asset outperforms the asset it is being exchanged for Volatility depends on both assets: = s 2 + k 2 2 s k

Written by Colby Schaeffer

11/17

MFE Study Guide Chapter 20 Brownian Motion & Itos Lemma

Fall 2007 2nd Edition

Introduction of terms 1) Stochastic process is a random process that is also a function of time. 2) Brownian motion is a continuous stochastic process 3) Diffusion process is Brownian motion where uncertainty increases over time 4) Martingale is a stochastic process for which E[Z(t2)] = Z(t1) if t2 > t1 Arithmetic Brownian Motion Z(0) = 0, Z(t + s) Z(t) ~ N(0, s), Z(t) is continuous

dX(T) = dt + dZ(t)

X(t) = X(a) + (t a) + t a

: volatility or variance factor : drift factor


Ornstein-Uhlembeck Process Variation of Arithmetic Brownian motion

dX(t) = ( X(t))dt + X(t)dZ


Geometric Brownian Motion

d ln[X (t )] =

dX (t ) = dt + dZ (t ) X (t )
2 )(t a) + t a

X(t) = X(a)e( 0.5


Itos Lemma

dC =

C 2C C dS + 0.5 2 (dS )2 + dt S t S

Multiplication Table dt dZ dt 0 0 dZ 0 dt

Written by Colby Schaeffer

12/17

MFE Study Guide Sharpe Ratio r = expected return per unit risk

Fall 2007 2nd Edition

If AND THEN

dS1 = 1S1dt + 1S1dZ dS 2 = 2S 2dt + 2S 2dZ


1 r 2 r = 1 2

Written by Colby Schaeffer

13/17

MFE Study Guide

Fall 2007 2nd Edition

Chapter 24 Interest Rate Models A stochastic interest-rate model that assumes a flat yield curve cannot be arbitrage-free. Arithmetic: dr = dt + dZ (similar to Arithmetic Brownian Motion) Problems: r < 0 is possible drift is positive, so r can goto infinity volatility is independent of interest rate Rendleman-Barter Model: dr = r dt + r dZ (similar to Geometric Brownian Motion) Problems: drift sends the interest rate to infinity Vasicek: dr = a (b r )dt + dZ Problems: volatility is independent

P (t ,T , r (t )) = A (t ,T )e B (t ,T )r (t )
A (t ,T ) = e
r (B (t ,T ) +t T ) B 2 2 4a

B (t ,T ) =

(1 e a (T t ) )

a
2

r =b +

a 2a

: Sharpe Ratio r : yield to maturity on infinitely lived bond These are fairly extensive formulas to memorize, but there is no way around it. Skip it if short on time or space in your head. Cox-Ingersoll-Ross (CIR) Model: dr = a (b r )dt + r dZ It's important to know that the Sharpe ratio for CIR isn't a constant; it depends on the short-term risk-free rate r according to where is a constant.

Written by Colby Schaeffer

14/17

MFE Study Guide

Fall 2007 2nd Edition

CIR yield to maturity formulas are too much for an SOA exam which says a lot. Model doesnt have problems like the other models have Mean reversion prevents interest rate from going to infinity. Interest rate models allow us to generate stochastic yield curves, but the models themselves may be too restrictive. Binomial Interest Rate Model All that is needed is a tree with short rates and p*. Unless given, assume p* = 0.5. Value bonds and options just like we did before, but it MUST BE DISCOUNTED AT EACH NODE due to varying interest rates. Types of Options 1) Calls/Puts American/European 2) Caps/Floors a. Strike Rate b. Notional Amount c. Frequency of Payment d. Length of contract Caps & floors control risk and promote parity. Simply, caps are like calls and floors are like puts. Caplet values are equal to the difference in the strike rate and given interest rate at a node multiplied by the notional amount. Black-Derman-Toy Model BDT Model is actually not that difficult. It is an binomial evaluation of the yield curve calibrated to actual results.

Pricing follows the same method as binomial interest rate trees. Written by Colby Schaeffer 15/17

MFE Study Guide

Fall 2007 2nd Edition

MFE Equations Sheet Put-Call Parity General Formula: Currency: Stock: Bond: Different Assets: C C C C C P P P P P = = = = = PV(FO,T K) x0e-rT Ke-rT S0 PV0,T(DIV) e-rTK B0 PV0,T(Coupons) e-rTK PV[Ft,T(S) - Ft,T(Q)] Risk Neutral Probability (of increase in stock)

p* =

e( r ) h d ud
h h

u = e( r ) h+ d = e( r ) h
u e(r )h d

Early exercise is not optimal if: C(St, K, T t) > St K At the prices Sh = Su, Sd, a replicating portfolio will satisfy: ( Su eh ) + (B erh) = Cu ( Sd eh ) + (B erh) = Cd Black-Scholes Pricing ln(Se t / Ke rt ) + 0.5 2 t d1 = t

Cox Ross-Rubinstein

u = e

h h

d = e

Lognormal

u = e (r 0.5

2 )+ h 2 ) h

d = e (r 0.5

d2 = d1 t

C = Se tN(d1 ) KertN(d2 ) P = Ke N(d2 ) Se


Option Greeks = e-t N(d1) Elasticity S = C option = stock | | Risk Premium: r = ( r) r Sharpe Ratio:
rt t

Schroders Method F = S PV(Div)

N(d1 )

F = S

S F

Path-dependent options Asian based on average price Barrier Knock-In + Knock-Out = Standard Option Other Exotic Options Compound CallOnOption PutOnOption = Option xert1 Gap: use trigger in d1, strike in PC parity Exchange: Volatility depends on both assets:

Overnight Profit OP = C 0 C 1 + (S1 S 0 ) (e r / 365 1)(S 0 C 0 )

= s 2 + k 2 2 s k

Written by Colby Schaeffer

16/17

MFE Study Guide

Fall 2007 2nd Edition

Delta-Gamma-Theta Approximation 1 C (S t + h ) = C (S t ) + + 2 + h 2 Where: = S t +h S t

Perpetual Options 2 x 2 + 2(r 0.5 2 )x 2r = 0

1 2 2 S + rS + 2 1 Var (Rh ,i ) = (S 22h )2 2

S Value: (H K ) H

h1

rC (S ) =

h Maximum H: H * = K 1 h1 1
Vasicek: dr = a (b r )dt + dZ Cox-Ingersoll-Rand (CIR) Model:

dX(T) = dt + dZ(t)

X(t) = X(a) + (t a) + t a

dr = a (b r )dt + r dZ
Black-Derman-Toy tree

X(t) = X(a)e
Itos Lemma

( 0.5 2 )(t a) + t a

dC =

C 2C C dS + 0.5 2 (dS )2 + dt S t S

Ornstein-Uhlembeck Process Variation of Arithmetic Brownian motion

dX(t) = ( X(t))dt + X(t)dZ

Written by Colby Schaeffer

17/17