MFE Study Guide (Fall 2007)

Notes from McDonalds Derivative Markets

Written by Colby Schaefer
MFE Study Guide Fall 2007
Introduction
The material in this quick study uide has been done to the best
o! my kno"lede# Some to$ics are only co%ered brie&y '(elta)*edin
and Ca$s+Floors, "hile other to$ics ha%e been omitted 'Equity -inked
.nnuities and Com$ound /$tions "+/ne (iscrete (i%idend,# .ll e0am
ti$s are marked in red1 This the 2
st
Edition o! my MFE study uide3 and
it may be u$dated in the !uture "ith better content# Comments and
questions may be directed %ia 4M to colby2252 on the .ctuarial
/ut$ost#
Acknowledgements6 (ay 7i3 .braham Weishus3 8ill Cross and ./
Member 9:ra%en;
Written by Colby Schaefer 2+27
MFE Study Guide Fall 2007
Ca!ter " # $arity and %ter %!tion &elationsi!s
/$tion E0ercise Style
.merican6 any time
Euro$ean6 end o! maturity
<alue o! other"ise identical o$tions6 Euro$ean = .merican
4ut)Call 4arity
General Formula' Call'>3 T, ? 4ut'>3 T, @ 4<'F
/3T
? >,
>6 strike $rice
T6 e0ercise time
4ut)Call $arity usually !ails !or .merican)style o$tions#
Currency6 C'>3 T, ? 4'>3 T, @ 0
0
e
)rAT
? >e
)rT
Stock' C'>3 T, ? 4'>3 T, @ S
0
? 4<
03T
'(B<, ? e
)rT
>
(ond6 C'>3 T, ? 4'>3 T, @ 8
0
? 4<
03T
'Cou$ons, ? e
)rT
>
)i*erent Assets' C'S
t
3 C
t
3 T ? t, ? 4'S
t
3 C
t
3 T ? t, @ 4<DF
t3T
'S, )

F
t3T
'C,E
0
0
6 current e0chane rate denominated as F+A
r
A
6 euro)denominated interest rate
r6 .merican or im$lied interest rate
(B<6 stream o! di%idends $aid on stock
Early E0ercise !or .merican /$tions
.merican)style call o$tions on a nondi%idend)$ayin stock should
ne%er be e0ercised $rior to e0$iration#
Early e0ercise is not o$timal i!6 C'S
t
3 >3 T ? t, G S
t
? >
When e0ercisin calls Hust $rior to a di%idend3 early e0ercise is
not o$timal at any time "here6 > ) 4<
t3T
'>, G 4<
t3T
'(B<,
.rbitrae Bnequalities '!or both .merican I Euro$ean,
THERE IS NO FREE LUNCH
>2 = >2 = >J
0 K C'>2, ? C'>2, K >2 ? >2
0 K 4'>2, ? 4'>2, K >2 ? >2
Li! o$tions are Euro$ean3 then the diference in o$tion $remiums must
be less than the !resent val"e o! the diference in strikes
#remi"ms decline at a decreasin$ rate as %e consider calls %it&
!ro$ressivel' &i$&er strike !rices( #remi"ms also decline for !"ts )"t
%&en t&e strike !rice monotonicall' decreases(
Written by Colby Schaefer J+27
MFE Study Guide Fall 2007
Con+e,ity o! o$tion $rice "#r#t# strike $rice
DC'>2, ? C'>2,E+'>2 ? >2, K DC'>2, ? C'>J,E+'>J ? >2,
D4'>2, ? 4'>2,E+'>2 ? >2, M D4'>J, ? 4'>2,E+'>J ? >2,
/$tion Trends
.merican o$tions become more %aluable as time to e0$iration
increases3 but the %alue o! Euro$ean o$tions may o u$ or do"n#
.s the strike $rice increases !or calls or decreases !or $uts3 the o$tions
become less %aluable "ith their $rice decreasin at a decreasin rate#
With di%idends3 loner term Euro$ean o$tions may be less %aluable
than shorter term Euro$ean o$tions#
Written by Colby Schaefer N+27
MFE Study Guide Fall 2007
Ca!ters -0. -- # (inomial $ricing
assumes that the stock $rice can chane to either an u$$er
%alue or to a lo"er %alue
If t&e o)served o!tion !rice di*ers from its t&eoretical !rice+ ar)itra$e
is !ossi)le,
u M e
'r ? O,h
M d
P6 delta3 the number o! shares to re$licate the o$tion $ayo!!
O6 di%idend rate
Q6 +olatility. the standard de%iation o! the rate o! return on stock
.t the $rices S
h
@ Su3 Sd3 a re$licatin $ort!olio "ill satis!y6
' Su e
h
, R '8 e
rh
, @ C
u
' Sd e
h
, R '8 e
rh
, @ C
d
Sisk Teutral 4robability 'o! increase in stock,
( )
*

r h
e d
p
u d
( )
( )
r h h
r h h
u e
d e


+

=
=
Su$$ose that the continuously com$ounded e0$ected return on the
stock is and that the stock does not $ay di%idends#
Multi$le $eriods6 "ork "ith !uture %alues and com$ute o$tion $rices
retros$ecti%ely
LTake ste$)by)ste$ ans"ers to si0 diits1
/ [ / ( )]

=
rt
binomial
C P e E C P value
.merican /$tions
For an .merican call3 the %alue o! the o$tion at a node is i%en
by
Call <alue @ ma0DS ? > L3 e
?rh
'$L <alue'U$, R '2 ) $L,<alue'(o"n,E
Written by Colby Schaefer 5+27
MFE Study Guide Fall 2007
Ls"itch to > ? S !or $uts
The %aluation o! .merican o$tions $roceeds as !ollo"s6
.t each node3 "e check !or early e,ercise#
B! the %alue o! the o$tion is reater "hen e0ercised3 "e
assin that %alue to the node# /ther"ise3 "e assin the
%alue o! the o$tion une0ercised#
Early E,ercise6 recei%e di%idends3 ad%ance $ayment o! strike
'interest,3 and lose insurance
>r G S
t
O Call oes
do"n
4ut oes u$
>r = S
t
O Call oes u$ 4ut oes
do"n
4ricin /$tions on /ther .ssets
Stock Inde, ? similar to nondi%idend)$ayin stocks
Currency ? re$lace stock $rice "ith currency e0chane rate and
di%idend rate "ith forei$n risk-free rate6
( ) +
=
r r h h
f
u e
Commodities ? re$lace di%idend rate "ith lease rate
(onds ? %olatility decreases o%er time and interest rates are %ariable
Forwards ? for%ards arent risk-free,
h
u e

=
Stocks 4ayin (iscrete (i%idends
The di%idend is taken of the Vrst node# The tree does not com$letely
recombine a!ter a discrete di%idend unless it is a $ercentae o! the
stock# .nother solution is to use6
Scroder/s Metod
F @ S ? 4<'(i%,
F S
S
F
=
.lternati%e Trees
Co, &oss#&u0instein

=
=
&
&
" e
d e
1ognormal
Written by Colby Schaefer W+27
MFE Study Guide Fall 2007
+

=
=
2
' 0#5 ,
2
' 0#5 ,
r &
r &
" e
d e
Mc)onald
.ssumes S @ S
ud
Written by Colby Schaefer 7+27
MFE Study Guide Fall 2007
Ca!ter -2 2 (lack#Scoles model
The 8lack)Scholes !ormula is a limitin case o! the binomial !ormula !or
the $rice o! a Euro$ean o$tion#

+
=
t rt 2
2
ln'Se + >e , 0#5 t
d
t
2 2
d d t =
Contrary to other !orms o! the d2 equation that you "ill see3 this is the
only one that you need to kno"# Currency and Futures o$tions re$lace
%ariables o! this equation3 but it remains the same#
t rt
2 2
C Se T'd , >e T'd ,

=
rt t
2 2
4 >e T' d , Se T' d ,

=
Where T'0, is the cumulati%e normal distribution !unction
.ssum$tions+4ro$erties
returns on stock are normally distributed and inde$endent o%er
time
%olatility and risk)!ree rate are both kno"n and constant
!uture di%idends are kno"n
there are no transaction costs+ta0es
Currency /$tions
Se$lace stock $rice "ith currency e0chane rate and the di%idend rate
"ith forei$n risk-free rate ? kno"n as Garman)>ohlhaen model
Futures
Se$lace stock $rice "ith !or"ard $rice and the di%idend rate "ith risk)
!ree rate#
%!tion Greeks
Formulas that e0$ress the chane in the o$tion $rice "hen an in$ut to
the !ormula chanes3 takin all other in$uts as V0ed#
P3 delta6 o$tion $rice chane "#r#t stock $rice chane
(elta is the only Greek that you are e0$ected to com$ute
P
call
@ e
)Ot
T'd
2
,
P
$ut
@ e
)Ot
T')d
2
,
P
call
@ P
$ut
R e
)Ot
L(elta o! a stock is al"ays equal to 2
Written by Colby Schaefer X+27
MFE Study Guide Fall 2007
Y3 amma6 measures con%e0ity /S chane in delta3 al"ays G 0
<ea6 tests i! %olatility is suZcient3 al"ays G 0
[3 theta6 o$tion $rice chane "#r#t# time to maturity chane3 usually =
0
\3 rho6 sensiti%ity to discounted strike $rice3 R !or call3 ) !or $ut
]3 $si6 sensiti%ity to discounted stock3 ) !or call3 R !or $ut
T&e .reek meas"re of a !ortfolio is t&e s"m of t&e .reeks of t&e
individ"al !ortfolio com!onents
Elasticity
tells us the risk o! the o$tion relati%e to the stock in ^terms
S
@
C

For a call _ M 23 "hile !or a $ut _ K 0

o$tion stock
` ` =
Sisk 4remium6 a ? r @ 'b ? r, _
Shar$e Satio6
r

$er!etual %!tions
+ =
2 2 2
2' 0#5 , 2 0 / r / r
Each 0 %alue is the $resent %alue o! 2 "hen a stock o! %alue S rises or
!alls to $rice *3 "here the %alue is 'S+*,
0
h
2
@ lo"er %alue o! 03 and h
2
@ hiher %alue o! 0
Calls
<alue6

2
' ,
&
S
H 0
H
Ma0imum *6

=

2
2
L
2
&
H 0
&
4uts 2 Hust re%erse * and > and h
2
and h
2
Written by Colby Schaefer c+27
MFE Study Guide Fall 2007
Ca!ter -3 2 )elta 4edging
Market makers "ant stable $ort!olios3 so they use delta hedin as a
method o! controllin risk#
%+ernigt $ro5t
= +
+ JW5
0 2 2 0 0 0
' , ' 2,' ,
r
O# C C S S e S C
)elta#Gamma#6eta A!!ro,imation
L(elta and (elta)Gamma a$$ro0imations are contained "ithin the
!ormula
+
= + + +
2
2
' , ' ,
2
t & t
C S C S &
Where6
+
=
t & t
S S
(lack#Scoles 7ormula
This is diferent than the 8lack)Scholes ECU.TB/T that "as used !or
$ricin o$tions# Sather3 this equation is a !unction o! the reeks3 stock
$rice3 %olatility3 and risk)!ree rate#
= + +
2 2
2
' ,
2
rC S S rS
=
2 2 2
3
2
' , ' ,
2
& i
1ar R S &
Written by Colby Schaefer 20+27
MFE Study Guide Fall 2007
Ca!ter -8 2 E,otic %!tions
.sian /$tions ? based on the arithmetic+eometric a%erae o!
underlyin asset+strike $rice
Luse!ul !or hedin currency e0chane3 %ariable annuities3 and
reducing +olatility
Geometric'S, = .rithmetic'S,
8arrier /$tions ? $ayof de$ends i! $rice o! asset reaches a barrier
le%el
$ayof and o$tion $remium is less %aluable than those o!
standard o$tions
2# >nock /ut ? o$tion oes out o! e0istence i! $rice reaches
barrier
2# >nock Bn ? o$tion 9comes into $lay; i! $rice reaches barrier
J# Sebate ? V0ed $ayment i! asset $rice reaches barrier
>nock)Bn R >nock)/ut @ Standard /$tion
Com!ound %!tion ? o$tion "hose underlyin asset is another o$tion
that e0$ires later
Com$ound /$tion 4arity
06 strike $rice o! com$ound o$tion
t
2
6 e0$iry o! com$ound o$tion
t
2
6 e0$iry o! underlyin o$tion
Call/n/$tion ? 4ut/n/$tion @

rt
2
/$tion 0e
Ga$ /$tions ? o$tion "ith trier >
2
'$rice that o$tion must be
e0ercised, and strike $rice >
2
that difer3 election is not o$timald Use
>
2
!or $ut)call $arity
E0chane /$tions ? lets you recei%e an asset in e0chane !or another
at time T3 $ays of only i! the o$tion asset out$er!orms the asset it is
bein e0chaned !or
<olatility de$ends on both assets6 = +
2 2
s k s k
2
Written by Colby Schaefer 22+27
MFE Study Guide Fall 2007
Ca!ter 20 2 (rownian Motion 9 Ito/s 1emma
Bntroduction o! terms
1) Stocastic !rocess is a random $rocess that is also a !unction
o! time#
2) (rownian motion is a continuous stochastic $rocess
3) )i*usion !rocess is 8ro"nian motion "here uncertainty
increases o%er time
4) Martingale is a stochastic $rocess !or "hich EDe't
2
,E @ e't
2
, i! t
2

G t
2
.rithmetic 8ro"nian Motion
e'0, @ 03 e't R s, ? e't, f T'03 s,3 e't, is continuous
= + dg'T, dt de't,
= + + g't, g'a, 't a, t a
6 %olatility or %ariance !actor
6 dri!t !actor
/rnstein)Uhlembeck 4rocess
<ariation o! .rithmetic 8ro"nian motiond
dg't, ' g't,,dt g't,de = +
Geometric 8ro"nian Motion
= = +
' ,
lnD ' ,E ' ,
' ,
d2 t
d 2 t dt d3 t
2 t
+
=
2
' 0#5 ,'t a, t a
g't, g'a,e
Btohs -emma
2
2
2
0#5 ' ,
C C C
dC dS dS dt
S t S

= + +

Multi$lication Table
dt de
dt 0 0
de 0 dt
Written by Colby Schaefer 22+27
MFE Study Guide Fall 2007
Shar$e Satio
@

r
9e0$ected return $er unit risk;
B!
= +
2 2 2 2 2
dS S dt S d3
.T(
= +
2 2 2 2 2
dS S dt S d3
T*ET



=
2 2
2 2
r r
Written by Colby Schaefer 2J+27
MFE Study Guide Fall 2007
Ca!ter 28 2 Interest &ate Models
. stochastic interest)rate model that assumes a &at yield cur%e cannot
be arbitrae)!ree#
Aritmetic6 = + dr dt d3 'similar to .rithmetic 8ro"nian Motion,
4roblems6
r = 0 is $ossible
dri!t is $ositi%e3 so r can oto inVnity
%olatility is inde$endent o! interest rate
&endleman#(arter Model' = + dr r dt r d3 'similar to Geometric
8ro"nian Motion,
4roblems6
dri!t sends the interest rate to inVnity
:asicek' = + ' , dr a ) r dt d3
4roblems6
%olatility is inde$endent

=
' 3 , ' ,
' 3 3 ' ,, ' 3 ,
4 t T r t
# t T r t 5 t T e

+
=
2 2
' ' 3 , ,
N
' 3 ,
4
r 4 t T t T
a
5 t T e

=
' ,
'2 ,
' 3 ,
a T t
e
4 t T
a

= +
2
2
r )
a a
i6 Shar$e Satio
r 6 yield to maturity on inVnitely li%ed bond
These are !airly e0tensi%e !ormulas to memorije3 but there is no "ay
around it# Ski$ it i! short on time or s$ace in your head#
Co,#Ingersoll#&and (CI&) Model' = + ' , dr a ) r dt rd3
CBS yield to maturity !ormulas are too much !or an S/. e0am "hich
says a lot#
Model doesnht ha%e $roblems like the other models ha%ed 9Mean
re%ersion; $re%ents interest rate !rom oin to inVnity#
Written by Colby Schaefer 2N+27
MFE Study Guide Fall 2007
Bnterest rate models allo" us to enerate stochastic yield cur%es3 but
the models themsel%es may be too restricti%e#
(inomial Interest &ate Model
.ll that is needed is a tree "ith short rates and $L# Unless i%en3
assume $L @ 0#5#
<alue bonds and o$tions Hust like "e did be!ore3 but it MUST 8E
(BSC/UTTE( .T E.C* T/(E due to %aryin interest rates#
Ty$es o! /$tions
2, Calls+4uts ? .merican+Euro$ean
2, Ca$s+Floors
a# Strike Sate
b# Totional .mount
c# Frequency o! 4ayment
d# -enth o! contract
Ca$s I &oors control risk and $romote $arity# Sim$ly3 ca$s are like
calls and &oors are like $uts# Ca$let %alues are equal to the diference
in the strike rate and i%en interest rate at a node multi$lied by the
notional amount#
(lack#)erman#6oy Model
8(T Model is actually not that diZcult# Bt is an binomial e%aluation o!
the yield cur%e calibrated to actual results#
4ricin !ollo"s the same method as binomial interest rate trees#
Written by Colby Schaefer 25+27
MFE Study Guide Fall 2007
MFE E;uations Seet
4ut)Call 4arity
General Formula6 C ) 4 @ 4<'F
/3T
? >,
Currency6 C ) 4 @ 0
0
e
)rAT
? >e
)rT
Stock6 C ) 4 @ S
0
? 4<
03T
'(B<, ? e
)rT
>
8ond6 C ) 4 @ 8
0
?
4<
03T
'Cou$ons, ? e
)rT
>
(iferent .ssets6 C ) 4 @ 4<DF
t3T
'S, )

F
t3T
'C,E
Early e0ercise is not o$timal i!6 C'S
t
3 >3 T ? t, G S
t
? >
.t the $rices S
h
@ Su3 Sd3 a re$licatin $ort!olio
"ill satis!y6
' Su e
h
, R '8 e
rh
, @ C
u
' Sd e
h
, R '8 e
rh
, @ C
d
8lack)Scholes 4ricin

+
=
t rt 2
2
ln'Se + >e , 0#5 t
d
t
2 2
d d t =
t rt
2 2
C Se T'd , >e T'd ,

=
rt t
2 2
4 >e T' d , Se T' d ,

=
/$tion Greeks
P @ e
)Ot
T'd
2
,
Elasticity
S
@
C

o$tion stock
` ` =
Sisk 4remium6 a ? r @ 'b ? r, _
Shar$e Satio6
r

%+ernigt $ro5t
= +
+ JW5
0 2 2 0 0 0
' , ' 2,' ,
r
O# C C S S e S C
Sisk Teutral 4robability 'o! increase in
stock,
( )
*

r h
e d
p
u d
( )
( )
r h h
r h h
u e
d e


+

=
=
u M e
'r ? O,h
M d
Co, &oss#&u0instein

=
=
&
&
" e
d e
1ognormal
+

=
=
2
' 0#5 ,
2
' 0#5 ,
r &
r &
" e
d e
Scroder/s Metod
F @ S ? 4<'(i%,
F S
S
F
=
4ath)de$endent o$tions
Asian ? based on a%erae $rice
(arrier
>nock)Bn R >nock)/ut @ Standard /$tion
/ther E0otic /$tions
Com!ound
Call/n/$tion ? 4ut/n/$tion @

rt
2
/$tion 0e
Ga!' use trier in d23 strike in 4C $arity
E,cange' <olatility de$ends on both
assets6 = +
2 2
s k s k
2
Written by Colby Schaefer 2W+27
MFE Study Guide Fall 2007
)elta#Gamma#6eta A!!ro,imation
+
= + + +
2
2
' , ' ,
2
t & t
C S C S &
Where6
+
=
t & t
S S
= + +
2 2
2
' ,
2
rC S S rS
=
2 2 2
3
2
' , ' ,
2
& i
1ar R S &
= + dg'T, dt de't,
= + + g't, g'a, 't a, t a
+
=
2
' 0#5 ,'t a, t a
g't, g'a,e
Btohs -emma
2
2
2
0#5 ' ,
C C C
dC dS dS dt
S t S

= + +

/rnstein)Uhlembeck 4rocess
<ariation o! .rithmetic 8ro"nian motiond
dg't, ' g't,,dt g't,de = +
4er$etual /$tions
+ =
2 2 2
2' 0#5 , 2 0 / r / r
<alue6

2
' ,
&
S
H 0
H
Ma0imum *6

=

2
2
L
2
&
H 0
&
:asicek' = + ' , dr a ) r dt d3
Co,#Ingersoll#&and (CI&) Model'
= + ' , dr a ) r dt rd3
(lack#)erman#6oy tree
Written by Colby Schaefer 27+27