Formulas for Math 423 Final Exam

1 (1 + r)n
1. The present value factor of an annuity is P A(r, n) = ;
r
rd
2. The risk-neutral probability p = ;
ud
1
3. In the binomial tree model with time step = N, for n = 0, 1, , N , the stock price at time
t = n is given by S(t) = S(0) exp(mt + w(t));

4. Itos Formula: Given dX(t) = a(t)dt + b(t)dW (t),

h G G 1 2G i G
dG(t, X(t)) = (t, X(t)) + a(t) (t, X(t)) + b2 (t) 2 (t, X(t)) dt + b(t) (t, X(t))dW (t)
t x 2 x x

5. The variance of the return on a portfolio is given by

V ar(KV ) = w12 V ar(K1 ) + w22 V ar(K2 ) + 2w1 w2 Cov(K1 , K2 )

6. If 12 = 1, then V = 0 when 1 6= 2 and

2 1
w1 = , w2 = .
1 2 1 2

(Short sales are necessary, since either w1 or w2 is negative. )

7. If 12 = 1, then V = 0 for

2 1
w1 = , w2 = .
1 + 2 1 + 2

(Not short sales are necessary, since both w1 or w2 are positive.)

8. For 1 < 12 < 1, the portfolio with minimum variance is attained at

12 12 1 2
w2 = s0 = .
12 + 22 212 1 2

9. In the case of several securities, V2 = V ar(KV ) = wCwT

10. The portfolio with the smallest variance in the attainable set has weights

uC1
w = .
uC1 uT

11. The weight w of any portfolio belonging to the efficient frontier (except for the minimum
variance portfolio ) satisfy the condition wC = m u for some > 0 and R.

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 12. The gradient V and intercept V of the line of best fit

Cov(KV , KM )
V = 2 , V = V V M .
M

13. Put-Call Parity Estimates (for American options):

S(0) XerT C A P A S(0) div0 X.

14. Bounds for European Options:

max{S(0) div0 XerT , 0} C E < S(0) div0 ,

max{XerT S(0) + div0 , 0} P E < XerT .

15. Bounds for American Options:

max{0, S(0) div0 XerT , S(0) X} C A < S(0)

max{0, XerT S(0) + div0 , X S(0)} P A < X

Note: 13-15 are versions for dividend-paying stocks with div0 denoting the present
value of dividends. As to the stocks paying no dividend, simply take div0 = 0.

16. replicating portfolio for one-step binomial tree model:

f (S u ) f (S d )
x(1) = ;
Su Sd

(1 + d)f (S ) (1 + u)f (S d )
u
y(1) = .
(u d)(1 + r)

17. Cox-Ross-Rubinstein Formula: In the binomial model the price of a European call and put
option with strike price X to be exercised after N time steps is given by

C E (0) = S(0)[1 (m 1, N, q)] (1 + r)N X[1 (m 1, N, p )],

P E (0) = S(0)(m 1, N, q) + (1 + r)N X(m 1, N, p ),
1+u
where m is the smallest integer such that S(0)(1 + u)k (1 + d)N k > X, q = p and
Pn N k 1+r
(n, N, p) = N k denotes the cumulative binomial distribution with N
k=0 k p (1 p)
trials and probability p of success in each trial.

18. In the Black-Scholes formula:

ln S(t)
X + (r + 1 2 )(T t) ln S(t)
X + (r 1 2 )(T t)
d1 (t) = 2 , d2 (t) = d1 (t) T t = 2 .
T t T t

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19. The Greeks for European call option:

deltaC E = N (d1 (t)),

1 d2
1 (t)
gammaC E = p e 2 ,
S 2(T t)
S d2
1 (t)
thetaC E = p e 2 rXer(T t) N (d2 (t)),
2 2(T t)

S T t d21 (t)
vegaC E = e 2 ,
2
rhoC E = (T t)Xer(T t) N (d2 (t)).

20. The duration of the coupon bond is defined to be

n1 C1 e n1 y + n2 C2 e n2 y + + nN 1 CN 1 e nN 1 y + nN (CN + F )e nN y
D(y) =
P (y)

where P (y) is the current price of the coupon bond:

P (y) = C1 e n1 y + C2 e n2 y + + CN 1 e nN 1 y + (CN + F )e nN y

21. The forward rate over the time [M , N ] determined at time n < M < N is defined by

ln B(n, M ) ln B(n, N )
f (n, M, N ) = .
(N M )

22. The bond price is given by

B(n, N ) = exp{ f (n, n) + f (n, n + 1) + + f (n, N 1) }.

23. The term structure y(n, N ) can be expressed by

f (n, n) + f (n, n + 1) + + f (n, N 1)

y(n, N ) = .
N n