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A Discussion of Financial Economics in Actuarial Models A Preparation for the Actuarial Exam MFE/3F

Marcel B. Finan

Arkansas Tech University

c All Rights Reserved

Preliminary Draft

July 7, 2011

2

To Pallavi and Amin

Preface

This is the third of a series of books intended to help individuals to pass actuarial exams. The present manuscript covers the financial economics segment of Exam M referred to by MFE/3F. The flow of topics in the book follows very closely that of McDonald’s Derivatives Markets. The book covers designated sections from this book as suggested by the 2009 SOA Syllabus. The recommended approach for using this book is to read each section, work on the embedded examples, and then try the problems. Answer keys are provided so that you check your numerical answers against the correct ones. Problems taken from previous SOA/CAS exams will be indicated by the symbol . This manuscript can be used for personal use or class use, but not for commercial purposes. If you find any errors, I would appreciate hearing from you: mfinan@atu.edu

Marcel B. Finan Russellville, Arkansas May 2010

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4

PREFACE

Contents

Preface

3

Parity and Other Price Options Properties

 

7

1 A Review of Options

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8

2 Put-Call Parity for European Options

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20

3 Put-Call Parity of Stock Options

 

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26

4 Conversions and Reverse Conversions .

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34

5 Parity for Currency Options

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39

6 Parity of European Options on Bonds

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44

7 Put-Call Parity Generalization

 

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49

8 Labeling Options: Currency Options

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55

9 No-Arbitrage Bounds on Option Prices

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60

10 General Rules of Early Exercise on American Options

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67

11 Effect of Maturity Time Growth on Option Prices

 

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76

12 Options with Different Strike Prices but Same Time to Expiration

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82

13 Convexity Properties of the Option Price Functions

 

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88

Option Pricing in Binomial Models

 

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14 Single-Period Binomial Model Pricing of European Call Options

 

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98

15 Risk-Neutral Option Pricing in the Binomial Model: A First Look

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107

16 Binomial Trees and Volatility

 

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112

17 Multi-Period Binomial Option Pricing Model

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118

18 Binomial Option Pricing for European Puts .

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123

19 Binomial Option Pricing for American Options .

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129

20 Binomial Option Pricing on Currency Options

 

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135

21 Binomial Pricing of Futures Options .

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141

22 Further Discussion of Early Exercising

 

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147

23 Risk-Neutral Probability Versus Real Probability .

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153

5

6

CONTENTS

24 Random Walk and the Binomial Model

 

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163

25 Alternative Binomial Trees

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169

26 Estimating (Historical) Volatility .

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175

The Black-Scholes Model

 

181

27 The Black-Scholes Formulas for European Options .

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182

28 Applying the Black-Scholes Formula To Other Assets

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188

29 Option Greeks: Delta, Gamma, and Vega .

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198

30 Option Greeks: Theta, Rho, and Psi .

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207

31 Option Elasticity and Option Volatility

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214

32 The Risk Premium and Sharpe Ratio of an Option .

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221

33 Profit Before Maturity: Calendar Spreads

 

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229

34 Implied Volatility

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234

Option Hedging

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35 Delta-Hedging

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242

36 Option Price Approximations: Delta and Delta-Gamma Approximations

 

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37 The Delta-Gamma-Theta Approximation and the Market-Maker’s Profit

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38 The Black-Scholes Analysis

 

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263

39 Delta-Gamma Hedging

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268

An Introduction to Exotic Options

 

273

40 Asian Options

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274

41 European Barrier Options

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280

42 Compound European Options

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286

43 Chooser and Forward Start Options

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292

44 Gap Options .

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300

45 Exchange Options .

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306

The Lognormal Stock Pricing Model

 

313

46 The Normal Distribution

 

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314

47 The Lognormal Distribution

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325

48 A Lognormal Model of Stock Prices

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330

49 Lognormal Probability Calculations

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338

50 Conditional Expected Price and a Derivation of Black-Scholes Formula

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345

CONTENTS

7

Option Pricing Via Monte Carlo Simulation

 

351

51 Option Valuation as a Discounted Expected Value

 

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352

52 Computing Normal Random Numbers

 

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357

53 Simulating Lognormal Stock Prices

 

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362

54 Monte Carlo Valuation for European Options .

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365

55 Monte Carlo Valuation of Asian Options

 

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370

56 Control Variate Method

 

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377

57 Antithetic Variate Method and Stratified Sampling .

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384

Brownian Motion

389

58 Brownian Motion

 

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390

59 Arithmetic Brownian Motion

 

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396

60 Geometric Brownian Motion

 

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401

61 Ito Process Multiplication Rules

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405

62 Sharpe ratios of Assets that Follow Geometric Brownian Motions .

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410

63 The Risk-Neutral Measure and Girsanov’s Theorem

 

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417

64 Single Variate Itˆo’s Lemma

 

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421

65 Valuing a Claim on S a

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427

The Black-Scholes Partial Differential Equation

 

433

66 Differential Equations for Riskless Assets

 

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434

67 Derivation of the Black-Scholes PDE

 

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438

68 The Black-Scholes PDE and Equilibrium Returns

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444

69 The Black-Scholes Equation and the Risk Neutral Pricing .

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448

Binary Options

451

70 Cash-or-Nothing Options

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452

71 Asset-or-Nothing Options

 

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458

72 Supershares

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