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# MFE Reference

Nobody22
May 11, 2010
Variables
S = Stock price
F = Forward price
K = Strike price
C = Call option
P = Put option
r = Continuous risk-free interest rate
= Continuous dividend rate
t = Time
= Volatility (Normal distribution)
= Shares of stock to replicate option
B = Amount to borrow to replicate option
p = % Chance stock will increase (using r)
p = % Chance stock will increase (using )
q = % Chance stock will decrease
u = Ratio increase in the price
d = Ratio decrease in the price
= Expected rate of return on a stock
= Expected rate of return on an option
C
0
= Current value of a stock
C
i
= The value of the stock if it ( H=increases, L=decreases)
U
i
= The utility value of a dollar if the stock (H=increases, L=decreases)
s = Sample volatility
x = Sample average ratio of price movement

2
= Second raw empirical moment
n = Number of stock movements
m = Mean of lognormal model
v = Volatility of lognormal model
= Change in stock price
= Sharp Ratio
= Correlation Coecient
X(t) = Arithmetric Brownian Motion
Z(t) = Geometric Brownian Motion
Formulas
Put-Call Parity
C P = S
0
e
t
Ke
rt
Replicating Portfolio
C = S +B
= e
rt
[p

C
u
+ (1 p

)C
d
]
=
_
C
u
C
d
S(u d)
_
e
t
B =
_
uC
d
dC
u
u d
_
e
rt
Rate of return relationship
Ce
t
= Se
t
+Be
rt
Utility Value
Q
H
= pU
H
Q
L
= qU
L
1
1 +r
= Q
H
+Q
L
C
0
= Q
H
C
H
+Q
L
C
L
p

=
Q
H
Q
H
+Q
L
=
pU
H
pU
H
+qU
L
=
pC
H
+qC
L
C
0
1
Estimating volatility
x
i
= ln
_
S
t
S
t1
_

2
=
n

i=1
x
2
i
n
x =
ln
_
S
n
S
0
_
n
s
2
=
n
n 1
(
2
x
2
)
Must annualize from interval period
Building Binomial Trees
Using forward rates
u = e
(r)t+

t
d = e
(r)t

t
Risk Neutral Pricing
p

=
e
(r)t
d
u d
p

=
1
1 +e

t
Using forward rates
Cox-Ross-Rubinstein
u = e

t
d = e

t
Lognormal (Jarrow-Rudd)
u = e
(r0.5
2
)t+

t
d = e
(r0.5
2
)t

t
For futures option
p =
1 d
u d
u = e

t
d = e

t
=
C
u
C
d
F(u d)
B = Option Price
All trees
u
d
= e
2

t
Lognormal model
m = t = ( 0.5
2
)t
v =

t
E[S
t
|S
0
] = S
0
e
(+0.5
2
)t
Median = S
0
e
t
Mode = S
0
e
(
2
)t
Condence Int. = S
0
e
mN(...)v
Note: The following are not set to PV
Pr(S
t
< K) = N(d
2
)
Pr(S
t
> K) = N(d
2
)
PE[S
t
|S
t
< K] = S
0
e
()t
N(d
1
)
PE[S
t
|S
t
> K] = S
0
e
()t
N(d
1
)
E[C
payoff
] = S
0
e
()t
N(d
1
) KN(d
2
)
=
1
n
ln
S
n
S
0
= Data
= Put each ln
S
t
S
t1
into Data

2
=
n
n 1
_
_
n

1
_
ln
S
t
S
t1
_
2

_
n

1
ln
S
t
S
t1
_
2
_
_
Black-Scholes
d
1
=
ln
_
S
0
K
_
+ (r + 0.5
2
)t

t
=
ln
_
S
0
e
t
Ke
rt
_
+ 0.5
2
t

t
d
2
= d
1

t
=
ln
_
S
0
K
_
+ (r 0.5
2
)t

t
C = S
0
e
t
N(d
1
) Ke
rt
N(d
2
)
P = Ke
rt
N(d
2
) S
0
e
t
N(d
1
)

call
= e
t
N(d
1
)

put
= e
t
N(d
1
)
=
call
e
t
Note: Future prices disregard and r
Elasticity
=
S
C

option
=
stock
||
r = ( r)
Sharpe Ratio
=
r

option
=
r

stock
Overnight Prot
Prot = C
0
C
1
+ (e
r/365
1)(S
0
C
0
)
approximation
C
h
= C
0
+ +

2
2
+h
Maket-maker Prot
Prot =
_
rh(S C) +

2
2
+h
_
Black-Scholes Equation
rC =
1
2
S
2

2
+rS +
year
Boyle-Emanuel (Re-hedging h-times)
Where h is a year:
V ar(R
h,i
) =
1
2
(S
2

2
h)
2
Annual Var =
1
2
(S
2

2
)
2
h
Exchange option volatility

2
option
=
2
S
+
2
K
2
S

K
Calculating of exotic options
N(d
i
)
S
=
e
d
2
i
/2
S

2T
Chooser-Option Formula
V = C(S, K, T) +e
(Tt)
P
_
S, Ke
(r)(Tt)
, t
_
American Call option with one discrete dividend:
= S
0
Ke
rt
+ CallonPut
_
S, K, D K
_
1 e
r(Tt)
__
If D K(1 e
r(Tt)
) < implicit put then its not rational to excercise early
Forward-Start Options
V = Se
t
N
Tt
(d
1
) cSe
r(Tt)t
N
Tt
(d
2
)
Geometric Brownian Motion
dS
t
S
t
= ( )dt +dZ(t)
P(S
t
> K) = 1 N
_
_
ln
_
K
S
0
_
( 0.5
2
)t

t
_
_
Note this is NOT B.S.
Arithmetic Brownian Motion
X(t) = t +Z(t)
P(S
t
> K) = 1 N
_
(K S
0
) t

t
_

arithmetric
=
geometric
0.5
2
Monte-Carlo Valuation
S
t
= S
0
e
m+vN
1
(U
random
)
Control Variate Method
E[X]

=

X + (E[Y ]

Y )
the Boyle modication adds B=Cov/Var(Y) resulting E[X]*=X+B(E[Y]-Y)
Relative Volatility
V ar(

X) = V ar(

X) +V ar(

Y ) 2Cov(

X,

Y )
It os Lemma
dC = C
S
dS + 0.5C
SS
(dS)
2
+C
t
dt
C
S
=
C
S
and C
SS
=

2
C
S
2
and C
t
=
C
t
Valuing a Forward on S
a
F
0,T
(S
a
) = S(0)
a
e
[a(r)+0.5a(a1)
2
]T
Ornstein-Uhlenbeck Process
dX = [ X]dt +dZ
BDT Model
R
dd
e
4
2

h
R
d
e
2
1

R
0
R
dd
e
2
2

h
R
d

R
dd
The Black Formula
F
0,t
B(t, t +s) =
B(0, t +s)
B(0, t)
d
1
=
ln
_
F
K
_
+ 0.5
2
t

t
d
2
= d
1

t
C = B(0, t)[FN(d
1
) KN(d
2
)]Essentially B.S., with the volatility being the time until the call
P = B(0, t)[KN(d
2
) FN(d
1
)]and the Bond being the factor which discounts to PV
Abandon hope, all who study past here!
Vasicek - CIR
Hedging Formulas
N
duration-hedge
=
(T
1
t)P(t, T
1
)
(T
2
t)P(t, T
2
)
N
delta-hedge
=
P
r
(r, t, T
1
)
P
r
(r, t, T
2
)
=
B(t, T
1
)P(r, t, T
1
)
B(t, T
2
)P(r, t, T
2
)
Bond Pricing
B = a
Tt|a
=
1 e
a(Tt)
a
P = Ae
Br
P
r
= BP
P
rr
= BP
r
q =
P
r

P
= B
=
a(b r)P
r
+ 0.5
2
P
rr
+P
t
P
=
r
q
Comparison of interest rate models
Name Formula Go Negative? Mean Revision? Volatility?
General dr = a(r)dt +(r)dz(t)
Rendleman-Bartter dr = ardt +rdz(t) No No Proportional
C.I.R. dr = a(b r)dt +

## rdz(t) No Yes Proportional

Vasicek dr = a(b r)dt +dz(t) Yes Yes Constant
Properties
Binomial Trees
d < e
(r)t
< u
If e
(r)t
> u, then sell the stock and loan \$.
If d > e
(r)t
, then borrow \$ and buy the stock.
CRR:
If t is large, e
(r)t
> e

t
violates arbitrage.
Lognormal:
If and t are large e
(r)t
> u = e
(r0.5
2
)t+

t
violates arbitrage.
Price movements with no gain/loss to the delta-hedger
S

h
Greeks
Greeks for portfolio=sum of Greeks
Elasticity for portfolio=weighted avg of elasticities
Exotic Options
Asian Options:
Geometric average Arithmetic average
Barrier Options:
Knock-in Option + Knock-out Option = Ordinary Option
Compound Options:
CallonOption - PutonOption = Option - xe
rt
Black-Scholes for Gap Options: (P.C.Parity works with Gap options)
Use trigger in B.S. formula, strike in C/P price
Maxima and Minima
max(S, K) = S +max(0, K S) = K +max(S K, 0)
max(cS, cK) = c max(S, K)when c > 0
min(S, K) +max(S, K) = S +K
Jesens Inequality
If f(x) is a convex function everywhere E[f(X)] f(E[X])
Caplets
Purchase 1+K amount of put options on bonds, for each year individually