EXAM MFE FORMULA SHEET Forward Contracts ‘The forward price is just the FV of the prepaid forward _ pe yt Fog = Fore Underlying Asset Forward Price Prepaid Forward Non-dividend paying stock T S,e! St Dividend paying stock 5 a : S,e'" —FV (Div) | St~ PV (Div) Stock Index (continuous r—8)T So raaee dividends) S,e4 ) Se Curreney (denominated in d, (x re \T -rfT delivery in Gear xe ying) xe 1 x= units (4A) Put Call Parity: C-P=PV(F)-PV(K) Futures: C-P=e"(Kyy,-K) No dividends: C-P=S,-Ke™ Discrete dividends: | C—P =Sy—PV(Div)-Ke"™ Continuous dividends: C- P = Se"? - Ke" Currency: C-P =x!" -Ke"a? Bonds: C—P = By - PV (coupons) - Ke" By ~ PV (coupons) = PV (cash flows after T)Exchange Options C(S,O,T)- P(S,Q,7) = Fu (S)— For (Q) $= price of underlying asset (S) Q= price of strike asset (K) Call/Put Relation C(S,Q,T) = P(Q,8,T) Currency Options oct Cl%,K,T)—P(%, KT) = xe" -Ke™ Xo = the exchange rate (d/f) £= rate on underlying currency d= rate on currency being paid (strike or denominated) “Dollar — denominated” means the strike price and premium are in dollars Duality If P(€1,$1.5,.5) = $0.03 <.67 To find C(SL6.5) wi K=S™ "Fuse duality ‘To find P($1,6,.5) wl K = sel a ** now use put/call parityAmerican Options S = Cine. (S, KT) = Cy, (SK) = max (0, PV (Fy) — PV (K)) K 2 Pay (S, KT) 2 Prag (S4K,T) 2 max (0, PV(K)- PV (A,r) Amer pur Stocks with no dividends An American call option is worth the same as a European call option An American put option may be worth more than a European put option Com = S, tees value at exercise now + K(I-e"7) + Pow - S(1-e*) implicit insurance ere ee by holding the call, We gain interest on K dividends lost by not exereising| Com KeK(I-e" eR >5,-K 20 With no dividends, C gio. = Cry 2S; —K Ifno dividends, it is never optimal to exercise an American call option early| Puts R= ES — KQ-) + Ge + s(ce*) peal lenegastieie seer value atexereise now by holding the put, we lose interest on K. insurance dividends kept by not exereising|Stocks dividends Calls Cy =(S, —K) + Pew 5 (1-e*") + K (1-e") Early call exercise NOT rational if = S(I-e*")_—< -e') eae ees ee dividends gained by early exercise interest lost by paying K early Early call exercise IS rational if S(I-e"*") > K(I-e"") +P Puts Pay = (K ~S,)+ Cop +8(1-€°")- K (I-27) Early put exercise NOT rational if K(l-e’") << S(I-e") WY Kearly dividends lost by early exercise es interest gained by reveivi Early put exercise IS rational if K(I-e”7)>S(I-e°" )+C Higher volatility makes options more expensive (better chance of payoff) Longer time to expiry always makes American options worth more Longer time to expiry always makes European options worth more if there are no dividends. If there are dividends, the longer-dated European options only might be worth more. Time to Expiry (for T >t YOPt ny (S, Ke" 7) > Opt (S, Kt)Different strike prices (for K; > Ky > K;) Direction C(K,) = C(K,) Higher strike makes call less valuable (have to pay more) P(K,) < P(K,) Higher strike makes put more valuable (get paid more) CALL VALUE PUT VALUE K Slope IC(K,)-C(K,) SK, ~K, C(K,)~C(K,)< PY (K, ~K,) if European P(K,)— P(K,)s K, —K, P(K,)— P(K,)< PV (K, — K,) if European Convexity a 2 JPR) = CCK) 2 C(K)- CK) a 20 (graph is concave up) K,-K, K,-K, aK ee 2 PCRs) — PUK) < P(K3)~ PK) ot 20 (graph is concave up) K,-K, K,-K, aKTo take advantage of arbitrage: 1) Write out an inequality to identify the mispricing 2) Get all terms on “greater” side of equation 3) Signs of terms suggest what to do (+= cash inflow = sell/borrow, - = cash outflow = buy/lend) If convexity is violated, the option in the middle is overpriced relative to the other 2 opt 1) Buy A of the K, options 2) Sell 1 of the K, options 3) Buy (1—A) of the K; options K-K, K,-K, A=Binomial Trees (stock, one period) Fa elt divovhi duel! veoh d<&"" 0, B0 Risk-neutral pricing S=(p*S, +0 pS, Je” V=(p*Cy += pCy)e™ ero) -d 1 u-d_—— govhat Pricing with True Probabilities ‘a = expected return on stock y = expected return on option hg u-d V =(pC, + (= p)Cy)e™ =(p*C, + pCa )e™Binomial Trees (general European option shortcut: Use the binomial distribution to compute the expected value of the ending nodes. For a 2-period tree: roxanne] ater wor ud (? \ene-e t(S\a-psy Currency Options Futures O=r, ua ev ae AG -rp vod daeoh 1-d rrp \h-oVh * = d= a 1) P u-d C=(p*C, +0 PC e™ B=C a ure F(u-d) Alternative Trees Cox-Ross-Rubenstein Lognormal (Jarrow-Rudd) 1-5-0507 \htovh u= evvh | ) ey 2\r daeoh ace’ 5-0.50"\h-ovhUtility Qu = PU, Q,=(- py, Co = Qu Cu + O.C, Oy +0, =— og PEu I= DIC,_ G On QO, +O, 5S peu, p*U,+0-p wy Note on volatility over time If variance is o” for a year, itis 07h for h years If standard deviation is & fora year, itis oVh for h years Estimating volatility from historical data @ = continuously compounded annual return 6& =sample standard deviation: unbiased sample variance = 5 n= # of observations (# ratios) p=# periods per year (to annualize volatility)A variable Z. has Standard Normal Distribution if Z ~ (0,1), ic. itis distributed normally with mean 0 and variance | A vatiable X ~ NV (11,07) can be converted to a standard normal variable Las follows: Z =2—# o Therefore X = t+ Zo Pv RO,t) = Inj ZL So Then S, = Sye"? If R(O,t) is normal, then S, is lognormal So if the continuously compounded returns are normally distributed, the stock price is lognormally distributed.Properties of Lognormal Variables 1) Lognormal variables cannot be negative (e* > 0) 2) The product of lognormal variables is lognormal (but not the sum) 3) For x~ (150), B(e*)=e"" 50? In(S,) ~ N[in(5,) +(a -6- 0.507) 4,07 | a = expected rate of return on the stock a -5= continuously compounded rate of appreciation 2, E(e’) = glttt0.So" t (a-8-0.507)provliz IS, = Spe (1 s.d. means Z = 1) -~5-0.502 Median (S,) = S,e7 7) Mean £(S,)= Sree «median < mean To construct 95% confidence interval on stock: (0-8-0507 )-rovia! (2-6-0507) rovigY 0° Doe To construct 95% confidence interval on returns: R* (0,0) = w( 5) RY (0,0 = uf) So 0Pricing European Options using the Lognormal Model Seo : In| - ~ |-0.S50°t 4 (x ia ovt St af ee }: 0.507 ani a= at es da =ai—-ovt P(S,K)=N(d2) PE[S, |S, K] = Spe! (at) PE[X|Y] E[X|¥]= PH)Black Scholes Formula C=F"(S)N(d,)- F?(K)N(da) P= F’(K)N(-d,)-F?(S)N(-d) [S52 } 050% d= Discrete dividends FPR) ovt d,=d,-ovt are invelevant when given a forward price Asset Call Premium Put Premium d, Stoel | se-N(d,)—Ke"N(dp) | Ke" N(-d,)-Se'N(-d,) Curreney | 6" N(d,)— Ke" N(dy) | Ke™N(—dy)- xe !'N(-d,) Futures Fe"'N(d,)—Ke™'N(d,) Black Formula Ke" N(~d,)- Fe “N(-d,) Black Formula Black Formula Futures have the same price as forwardsinf ©) +(r-3+0550°) fae : ovt Assumptions of Black Scholes 1) Continuously compounded returns on the stock are normally distributed and independent over time 2) Continuously compounded returns on the strike asset (the risk free rate) are known and constant 3) Volatility is known and constant 4) Dividends are known and constant 5) No transaction costs or taxes 6) You can short-sell or borrow any amount of money at the risk-free rateGreeks Greek OFChange | Sign for Long | Sign for Long Symbol price per. Call Put Delta | Increase in stock +81 : + = bet [- (A) price (8) bet [0,1] bet [-1,0] Gamma | increase in A per +81 I + a) increase in S Theta | Decrease intimeto | 1 day aaa a (8) expity (0) aed y Tncrease in volatility Vega (c) +1% point . a | Rho | Tnerease in interest ) rate (1) +1% point | : Tnerease in dividend psi (y) yield (5) 1% point a fa Delta (A) Neat = e"'N(d) Any = ~e"N (=d,) put An = Neat = & 81 =sum of the A's (use # of options, not values) ponfoo. As ST, At Tan a Dou Vega ay =Vega yuElasticity % change in option pri % change in stock price Qeatz! AsST,A. <0 AsST,Q,+ Q pul> =% of portfolio invested in stock option = Fstock O| Risk premium for a stock = @—r Risk premium for an option = y-r y-r=Q(a-r) (this also works for portfolios) Sharpe Ratio = For call: <— = —— (same as for a stock) yor -(a-r) Fput — Fstock For put: Spon _ Cyaine *Pratuep port =~ Q "port Cyatue Pvatue = weighted average of all Q's Holding Period Profit Gas) Profit = Cp —Cyyge “75 Profit = P, Ms) Pp orig: Implied Volatilities — implied volatility (>) is the o that sets the B-S price equal to the observed market price -Back it out of B-SDelta Hedging Involves buying/selling options and buying A shares of stock Initial Investment = AS’ —C Overnight Profit = 1) profit/loss on stock (A(S;—5y)) 2) profit/loss on options 3) initial investment with interest (e” =1)(as— Cc) Market-maker break even points: S+Sovh S-Sovh Delta-Gamma-Theta Approximation C(S,,,) CS) = Ae +050 2" +9) é is the change in stock price hand @ must be in same units Market Maker Profit =|—0.5T,e” — h@, —rh(A-S, —C(S,)) Hedging Multiple Greeks To Ar hedge a portfolio 1) Use another option to neutralize (set sum = 0 and find # of second option to buy/sell) 2) Calculate A of the new portfolio 3) Ahedge with shares of underlying stock to offset A of portfolio (i.e. If step 2 A is positive, you must sell stock)Greeks for Binomal Trees A,-A P(S,0) 2 1'(S,h) == (S,0)#1(S,h) Sud) 98,0) = Cd =O = Ape - 0.50 9€7 : 2h Rehedging Single Poriod Variance of Return (h in years) = 0.5 (Sor h) 2 Annual Variance of Return (h in years) = 0.5 (s °o°T) h Rehedging every h period (monthly means h = s )Exotic Options Asian Options Cacith, Avg Price = Max(0, ACS) ~ K) Pavith, Avg Price = Max(0, K — A(S)) Cavith, Avg Sttike = Max(0,S, — A(S))) Parith, Avg Strike = Max(0, A(S) —S;) Asian Option < European Option For average price option Value J asn t (ifn = 1, avg. price option = ordinary option) For average strike option Value t asn t (ifn = 1, avg. strike option = 0) Barrier Options Knock In = comes into existence if stock reaches barrier Knock Out = goes out of existence if stock reaches barrier Knock In + Knock Out = Ordinary Option Payoff still depends on strike K Barrier Option < Ordinary Option Rebate Option — pays off fixed amount if barrier is hit Maxima and Minima max(S,K)=S +max(0,K —S) = K +max(S- K,0) max(cS,cK) = cmax(S, K) min(S, K)+ max(S,K)=S+K)Compound Options CallOnCall = PutOnCall = C — xe" CallOnPut — PutOnPut = P — xe"! x= strike price of compound option t, = expiry of compound option < T (expiry of underlying option) Value of CallOnCall at ¢, = Max[C(S,,K,T -4,)-x,0] American Options with One Discrete Dividend Call yyy. = Sy — Ke" + CallOnPut| 8,K,D-K(l-e"" ®),4,7 strike priee of COP COP has strike price of D~K(1-e""") Amer It is optimal to exercise the American option at time ¢, if [ Put < D-K(I-e""™) -----> Don’t exercise COP at time 7) Exercise American Call at time fy --~ Don’t exercise American Call at time 4) --> Exercise COP at time Z,All or Nothing Options Asset or Nothing Call: Purchaser receives S, if S, > K, 0 otherwise S|S>K=Se"N(d,) Asset or Nothing Put: Purchaser receives S, if S, K, 0 otherwise c|S>K =ce""N(d,) Cash or Nothing Put: Purchaser receives c if S, < K, 0 otherwise e|S0 wane +050 ee lave oe) Lac P=de* P, =-BP P,, =B°P Rendleman-Bartter a) = ard +ordZ(0) Vacisek dr(t)=a(b-r())dt+ a(r)dZ(t) ary a 22 r(But-T) =e A=e@ . elt functions of T-t only, B= a CIR dr =a(b-r)at +r dz(0) or)Risk Neutral Process: dr = (a(r) + $o(r) dt + od Z(0) Sharpe Ratio _a(rt.G)-r _ a(rt.%)~ HN eat) alr) Vacisek: #(7,t)=¢ (a constant) CIR: (7,0) = ir where o(r) = ovr ( c YTM on infinitely-lived bond —In(P(1,t,7)) el) Mil aa of o Vacisek: 7 = Petia Sigs a 7 2ab 2 CIR: r=—~=——._ where y =,/(a-¢) +21 : a-pty ‘ ( 4) Delta-Gamma Approximation P.— pares 0.5 SOP, 24,0, or or ot where ¢ is the change in the interest rate