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MFE Study Guide

MFE Study Guide

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Published by ahpohy
SOA Exam MFE notes
equation sheet
SOA Exam MFE notes
equation sheet

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Published by: ahpohy on Apr 15, 2013
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11/09/2013

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 MFE Study Guide (Fall 2007)
Notes from McDonald’s Derivative Markets 
 Written by Colby Schaeffer
 
MFE Study Guide Fall 2007 2
nd
EditionWritten by Colby Schaeffer 2/17
Introduction
The material in this quick study guide has been done to the best of myknowledge. Some topics are only covered briefly (Delta-Hedging andCaps/Floors) while other topics have been omitted (Equity Linked Annuities andCompound Options w/One Discrete Dividend). All exam tips are marked in red! This the 1
st
Edition of my MFE study guide, and it may be updated in the futurewith better content. Comments and questions may be directed via PM tocolby2152 on the Actuarial Outpost.2
nd
Edition Notes: Jraven and fractl helped me tweak some little errors inthe study guide. An entirely revamped Spring 08 Edition will be out by March2008 with more on Brownian Motion, a better understanding but less detailedlook at the Greeks, an easier view of convexity, and perpetual options will beremoved.
 Acknowledgements
: Day Yi, Abraham Weishus, Bill Cross and AO Member “Jraven” 
 
MFE Study Guide Fall 2007 2
nd
EditionWritten by Colby Schaeffer 3/17
Chapter 9 - Parity and Other Option Relationships
Option Exercise Style
 
 American: any time
 
European: end of maturity Value of otherwise identical options: European < AmericanPut-Call Parity
General Formula:
Call(K, T) – Put(K, T) = PV(F
O,T
 – K)K: strike priceT: exercise timePut-Call parity usually fails for American-style options.
Currency
: C(K, T) – P(K, T) = x
0
e
-r
 €
T
– Ke
-rT
 
Stock:
C(K, T) – P(K, T) = S
0
– PV
0,T
(DIV) – e
-rT
Bond
: C(K, T) – P(K, T) = B
0
– PV
0,T
(Coupons) – e
-rT
Different Assets:
C(S
t
, Q
t
, T – t) – P(S
t
, Q
t
, T – t) = PV[F
t,T
(S) - F
t,T
(Q)]x
0
: current exchange rate denominated as $/
 €
 r
 €
: euro-denominated interest rater: American or implied interest rateDIV: stream of dividends paid on stock Early Exercise for American Options
 
 American-style call options on a nondividend-paying stock should never beexercised prior to expiration.
 
Early exercise is not optimal if: C(S
t
, K, T – t) > S
t
– K 
 
When exercising calls just prior to a dividend, early exercise is not optimalat any time where: K - PV
t,T
(K) > PV
t,T
(DIV) Arbitrage Inequalities (for both American & European)
THERE IS NO FREE LUNCH! 
K1 < K2 < K30
C(K1) – C(K2)
K2 – K10
P(K2) – P(K1)
K2 – K1*if options are European, then the difference in option premiums must be lessthan 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.

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