1Mathematical Logic

1.1 Introduction

1.2 Axiomatic Theory

1.3 Inferences

Proof by Contradiction

Proof by Induction

*1.6 Mathematical Logic

1.7 Applications to Finance

Exercises

2Number Systems and Functions

2.1 Numbers: Properties and Structures

2.1.1 Introduction

2.1.2 Natural Numbers

2.1.3 Integers

2.1.4 Rational Numbers

2.1.5 Real Numbers

*2.1.6 Complex Numbers

2.2 Functions

2.3 Applications to Finance

2.3.1 Number Systems

2.3.2 Functions

Present Value Functions

Accumulated Value Functions

Nominal Interest Rate Conversion Functions

Bond-Pricing Functions

Mortgage- and Loan-Pricing Functions

Preferred Stock-Pricing Functions

Common Stock-Pricing Functions

Portfolio Return Functions

Forward-Pricing Functions

3Euclidean and Other Spaces

3.1 Euclidean Space

3.1.1 Structure and Arithmetic

3.1.2 Standard Norm and Inner Product forRn

*3.1.3 Standard Norm and Inner Product forCn

3.1.4 Norm and Inner Product Inequalities forRn

*3.1.5 Other Norms and Norm Inequalities forRn

3.2 Metric Spaces

3.2.1 Basic Notions

3.2.2 Metrics and Norms Compared

*3.2.3 Equivalence of Metrics

3.3 Applications to Finance

3.3.1 Euclidean Space

Asset Allocation Vectors

Interest Rate Term Structures

Bond Yield Vector Risk Analysis

Cash Flow Vectors and ALM

3.3.2 Metrics and Norms

Sample Statistics

Constrained Optimization

Tractability of the lp-Norms: An Optimization Example

General Optimization Framework

4Set Theory and Topology

4.1 Set Theory

4.1.1 Historical Background

*4.1.2 Overview of Axiomatic Set Theory

4.1.3 Basic Set Operations

4.2 Open, Closed, and Other Sets

4.2.1 Open and Closed Subsets ofR

4.2.2 Open and Closed Subsets ofRn

*4.2.3 Open and Closed Subsets in Metric Spaces

*4.2.4 Open and Closed Subsets in General Spaces

4.2.5 Other Properties of Subsets of a Metric Space

4.3 Applications to Finance

4.3.1 Set Theory

4.3.2 Constrained Optimization and Compactness

4.3.3 Yield of a Security

5Sequences and Their Convergence

5.1 Numerical Sequences

5.1.1 Deﬁnition and Examples

5.1.2 Convergence of Sequences

5.1.3 Properties of Limits

*5.2 Limits Superior and Inferior

*5.3 General Metric Space Sequences

5.4 Cauchy Sequences

5.4.1 Deﬁnition and Properties

*5.4.2 Complete Metric Spaces

5.5 Applications to Finance

5.5.1 Bond Yield to Maturity

Interval bisection for bond yield

5.5.2 Interval Bisection Assumptions Analysis

6Series and Their Convergence

6.1 Numerical Series

6.1.1 Deﬁnitions

6.1.2 Properties of Convergent Series

6.1.3 Examples of Series

*6.1.4 Rearrangements of Series

6.1.5 Tests of Convergence

6.2 The lp-Spaces

6.2.1 Deﬁnition and Basic Properties

*6.2.2 Banach Space

*6.2.3 Hilbert Space

6.3 Power Series

*6.3.1 Product of Power Series

*6.3.2 Quotient of Power Series

6.4 Applications to Finance

6.4.1 Perpetual Security Pricing: Preferred Stock

6.4.2 Perpetual Security Pricing: Common Stock

6.4.3 Price of an Increasing Perpetuity

6.4.4 Price of an Increasing Payment Security

6.4.5 Price Function Approximation: Asset Allocation

6.4.6 lp-Spaces: Banach and Hilbert

7Discrete Probability Theory

7.1 The Notion of Randomness

7.2 Sample Spaces

7.2.1 Undeﬁned Notions

7.2.2 Events

7.2.3 Probability Measures

7.2.4 Conditional Probabilities

Law of Total Probability

7.2.5 Independent Events

7.2.6 Independent Trials: One Sample Space

*7.2.7 Independent Trials: Multiple Sample Spaces

7.3 Combinatorics

7.3.1 Simple Ordered Samples

With Replacement

Without Replacement

7.3.2 General Orderings

Two Subset Types

Binomial Coe‰cients

The Binomial Theorem

r Subset Types

Multinomial Theorem

7.4 Random Variables

7.4.1 Quantifying Randomness

7.4.2 Random Variables and Probability Functions

7.4.3 Random Vectors and Joint Probability Functions

7.4.4 Marginal and Conditional Probability Functions

7.4.5 Independent Random Variables

7.5 Expectations of Discrete Distributions

7.5.1 Theoretical Moments

Expected Values

Conditional and Joint Expectations

Mean

Variance

Covariance and Correlation

General Moments

General Central Moments

Absolute Moments

Moment-Generating Function

Characteristic Function

*7.5.2 Moments of Sample Data

Sample Mean

Sample Variance

Other Sample Moments

7.6 Discrete Probability Density Functions

7.6.1 Discrete Rectangular Distribution

7.6.2 Binomial Distribution

7.6.3 Geometric Distribution

7.6.4 Multinomial Distribution

7.6.5 Negative Binomial Distribution

7.6.6 Poisson Distribution

7.7 Generating Random Samples

7.8 Applications to Finance

7.8.1 Loan Portfolio Defaults and Losses

Individual Loss Model

Aggregate Loss Model

7.8.2 Insurance Loss Models

7.8.3 Insurance Net Premium Calculations

Generalized Geometric and Related Distributions

Life Insurance Single Net Premium

Pension Beneﬁt Single Net Premium

Life Insurance Periodic Net Premiums

7.8.4 Asset Allocation Framework

7.8.5 Equity Price Models in Discrete Time

Stock Price Data Analysis

7.8.7 Discrete Time European Option Pricing: Scenario Based

8Fundamental Probability Theorems

8.1 Uniqueness of the m.g.f. and c.f

8.2 Chebyshev’s Inequality

8.3 Weak Law of Large Numbers

8.4 Strong Law of Large Numbers

8.4.3 The Strong Law Approach

*8.4.4 Kolmogorov’s Inequality

*8.4.5 Strong Law of Large Numbers

8.5 De Moivre–Laplace Theorem

8.5.1 Stirling’s Formula

8.5.2 De Moivre–Laplace Theorem

8.5.3 Approximating Binomial Probabilities I

8.6 The Normal Distribution

8.6.1 Deﬁnition and Properties

8.6.2 Approximating Binomial Probabilities II

*8.7 The Central Limit Theorem

8.8 Applications to Finance

8.8.1 Insurance Claim and Loan Loss Tail Events

Risk-Free Asset Portfolio

Risky Assets

8.8.2 Binomial Lattice Equity Price Models as Dt?0

Parameter Dependence on Dt

Distributional Dependence on Dt

Real World Binomial Distribution as Dt?0

8.8.3 Lattice-Based European Option Prices as Dt?0

The Model

European Call Option Illustration

Black–Scholes–Merton Option-Pricing Formulas I

8.8.4 Scenario-Based European Option Prices as N?T

Option Price Estimates as N?T

Scenario-Based Prices and Replication

The Meaning of ‘‘Discontinuous’’

*The Metric Notion of Continuity

Sequential Continuity

9.2.3 Basic Properties of Continuous Functions

9.2.4 Uniform Continuity

9.2.5 Other Properties of Continuous Functions

9.2.6 Ho¨lder and Lipschitz Continuity

9.2.7 Convergence of a Sequence of Continuous Functions

*Series of Functions

*Interchanging Limits

*9.2.8 Continuity and Topology

9.3 Derivatives and Taylor Series

9.3.1 Improving an Approximation I

9.3.2 The First Derivative

9.3.3 Calculating Derivatives

A Discussion of e

9.3.4 Properties of Derivatives

9.3.5 Improving an Approximation II

9.3.6 Higher Order Derivatives

Analytic Functions

analytic functions

9.3.8 Taylor Series Remainder

9.4 Convergence of a Sequence of Derivatives

9.4.1 Series of Functions

9.4.2 Di¤erentiability of Power Series

Product of Taylor Series

*Division of Taylor Series

9.5 Critical Point Analysis

9.5.1 Second-Derivative Test

*9.5.2 Critical Points of Transformed Functions

9.6 Concave and Convex Functions

9.6.1 Deﬁnitions

9.6.2 Jensen’s Inequality

9.7 Approximating Derivatives

9.8 Applications to Finance

9.8.1 Continuity of Price Functions

9.8.2 Constrained Optimization

9.8.3 Interval Bisection

9.8.4 Minimal Risk Asset Allocation

9.8.5 Duration and Convexity Approximations

Dollar-Based Measures

Embedded Options

Rate Sensitivity of Duration

9.8.6 Asset–Liability Management

Surplus Immunization, Time tF0

Surplus Immunization, Time tI0

Surplus Ratio Immunization

9.8.7 The ‘‘Greeks’’

9.8.8 Utility Theory

Investment Choices

Insurance Choices

Gambling Choices

Utility and Risk Aversion

Examples of Utility Functions

9.8.9 Optimal Risky Asset Allocation

9.8.10 Risk-Neutral Binomial Distribution as Dt?0

Analysis of the Risk-Neutral Probability: q(Dt)

Risk-Neutral Binomial Distribution as Dt?0

*9.8.11 Special Risk-Averter Binomial Distribution as Dt?0

Analysis of the Special Risk-Averter Probability: q(Dt)

Special Risk-Averter Binomial Distribution as Dt?0

Details of the Limiting Result

9.8.12 Black–Scholes–Merton Option-Pricing Formulas II

10Calculus II: Integration

10.1 Summing Smooth Functions

10.2 Riemann Integration of Functions

10.2.1 Riemann Integral of a Continuous Function

10.2.2 Riemann Integral without Continuity

Finitely Many Discontinuities

*Inﬁnitely Many Discontinuities

10.5.2 The Derivative of an Integral

10.6 Improper Integrals

10.6.1 Deﬁnitions

10.6.2 Integral Test for Series Convergence

10.7 Formulaic Integration Tricks

10.7.1 Method of Substitution

10.7.2 Integration by Parts

*10.7.3 Wallis’ Product Formula

10.8 Taylor Series with Integral Remainder

10.9 Convergence of a Sequence of Integrals

10.9.1 Review of Earlier Convergence Results

10.9.2 Sequence of Continuous Functions

10.9.3 Sequence of Integrable Functions

10.9.4 Series of Functions

10.9.5 Integrability of Power Series

10.10 Numerical Integration

10.10.1 Trapezoidal Rule

10.10.2 Simpson’s Rule

10.11 Continuous Probability Theory

10.11.1 Probability Space and Random Variables

10.11.2 Expectations of Continuous Distributions

*10.11.3 Discretization of a Continuous Distribution

10.11.4 Common Expectation Formulas

Standard Deviation

10.11.5 Continuous Probability Density Functions

Continuous Uniform Distribution

Beta Distribution

Exponential Distribution

Gamma Distribution

Cauchy Distribution

Normal Distribution

Lognormal Distribution

10.11.6 Generating Random Samples

10.12 Applications to Finance

10.12.1 Continuous Discounting

10.12.2 Continuous Term Structures

Bond Yields

Forward Rates

Fixed Income Investment Fund

Spot Rates

10.12.3 Continuous Stock Dividends and Reinvestment

10.12.4 Duration and Convexity Approximations

10.12.5 Approximating the Integral of the Normal Density

Power Series Method

Upper and Lower Riemann Sums

Trapezoidal Rule

Simpson’s Rule

*10.12.6 Generalized Black–Scholes–Merton Formula

The Piecewise ‘‘Continuitization’’ of the Binomial Distribution

The ‘‘Continuitization’’ of the Binomial Distribution

The Limiting Distribution of the ‘‘Continuitization’’

The Generalized Black–Scholes–Merton Formula