MFE Study Guide (Fall 2007

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Notes from McDonald’s Derivative Markets Written by Colby Schaeffer

MFE Study Guide Fall 2007 Introduction The material in this quick study guide has been done to the best of my knowledge. All exam tips are marked in red! This the 1st Edition of my MFE study guide. Bill Cross and AO Member “Jraven” Written by Colby Schaeffer 2/17 . and it may be updated in the future with better content. Comments and questions may be directed via PM to colby2152 on the Actuarial Outpost. Acknowledgements: Day Yi. Some topics are only covered briefly (Delta-Hedging and Caps/Floors) while other topics have been omitted (Equity Linked Annuities and Compound Options w/One Discrete Dividend). Abraham Weishus.

T) = x0e-r€T – Ke-rT Stock: C(K. then the difference in option premiums must be less than the present value of the difference in strikes Premiums decline at a decreasing rate as we consider calls with progressively higher strike prices.Ft. • Early exercise is not optimal if: C(St. T – t) = PV[Ft.T(Q)] x0: current exchange rate denominated as $/€ r€: euro-denominated interest rate r: American or implied interest rate DIV: stream of dividends paid on stock Early Exercise for American Options • American-style call options on a nondividend-paying stock should never be exercised prior to expiration. Qt.PVt. Premiums also decline for puts but when the strike price monotonically decreases. T) = PV(FO. Qt. T) – P(K. T) – P(K. Currency: C(K.Parity and Other Option Relationships Option Exercise Style • American: any time • European: end of maturity Value of otherwise identical options: European < American Put-Call Parity General Formula: Call(K. T) – P(K.T(DIV) – e-rTK Bond: C(K. T) = S0 – PV0.T(DIV) Arbitrage Inequalities (for both American & European) THERE IS NO FREE LUNCH! K1 < K2 < K3 0 ≤ C(K1) – C(K2) ≤ K2 – K1 0 ≤ P(K2) – P(K1) ≤ K2 – K1 *if options are European.T(K) > PVt. T) = B0 – PV0.T(S) .T(Coupons) – e-rTK Different Assets: C(St.MFE Study Guide Fall 2007 Chapter 9 . early exercise is not optimal at any time where: K . T – t) – P(St. T – t) > St – K • When exercising calls just prior to a dividend.T – K) K: strike price T: exercise time Put-Call parity usually fails for American-style options. T) – Put(K. Written by Colby Schaeffer 3/17 . K.

strike price [C(K1) – C(K2)]/(K2 – K1) ≤ [C(K2) – C(K3)]/(K3 – K2) [P(K2) – P(K1)]/(K2 – K1) ≥ [P(K3) – P(K2)]/(K3 – K2) Fall 2007 Option Trends American options become more valuable as time to expiration increases. longer term European options may be less valuable than shorter term European options. Written by Colby Schaeffer 4/17 . but the value of European options may go up or down. As the strike price increases for calls or decreases for puts. the options become less valuable with their price decreasing at a decreasing rate. With dividends.t.r.MFE Study Guide Convexity of option price w.

Multiple periods: work with future values and compute option prices retrospectively *Take step-by-step answers to six digits! C / P = e− rt E[C / P binomial ( value)] American Options • For an American call. Sd.MFE Study Guide Fall 2007 Chapters 10. arbitrage is possible… u ≥ e(r – δ)h ≥ d Δ: delta. the standard deviation of the rate of return on stock At the prices Sh = Su. the number of shares to replicate the option payoff δ: dividend rate σ: volatility. the value of the option at a node is given by Call Value = max[S – K *. e–rh(p* Value(Up) + (1 .p*)Value(Down)] Written by Colby Schaeffer 5/17 . a replicating portfolio will satisfy: δ (∆ × Su × e h ) + (B × erh) = Cu δ (∆ × Sd × e h ) + (B × erh) = Cd Risk Neutral Probability (of increase in stock) e( r −δ ) h − d p = u−d * u = e( r −δ ) h+σ d = e ( r −δ ) h−σ h h Suppose that the continuously compounded expected return on the stock is α and that the stock does not pay dividends. 11 .Binomial Pricing • assumes that the stock price can change to either an upper value or to a lower value If the observed option price differs from its theoretical price.

• Early Exercise: receive dividends. The tree does not completely recombine after a discrete dividend unless it is a percentage of the stock. – If the value of the option is greater when exercised. advance payment of strike (interest). we check for early exercise. Otherwise. Another solution is to use: Schroder’s Method F = S – PV(Div) S σF = σS F Alternative Trees Cox Ross-Rubinstein u = eσ h h d = e −σ Lognormal Written by Colby Schaeffer 6/17 . and lose insurance Kr > Stδ Call goes Put goes up down Kr < Stδ Call goes up Put goes down • Pricing Options on Other Assets Stock Index – similar to nondividend-paying stocks Currency – replace stock price with currency exchange rate and dividend rate with foreign risk-free rate: Commodities – replace dividend rate with lease rate Bonds – volatility decreases over time and interest rates are variable Forwards – forwards aren’t risk-free… σ h u=e ( r − r f ) h +σ h u =e Stocks Paying Discrete Dividends The dividend is taken off the first node. we assign that value to the node.MFE Study Guide *switch to K – S for puts Fall 2007 The valuation of American options proceeds as follows: – At each node. we assign the value of the option unexercised.

MFE Study Guide u = e (r −δ− 0.5σ McDonald Assumes S = Sud Written by Colby Schaeffer 7/17 .5σ 2) + σ h 2) −σ h Fall 2007 d = e (r −δ− 0.

d1 = ln(Se−δ t / Ke−rt ) + 0. this is the only one that you need to know. Option Greeks Formulas that express the change in the option price when an input to the formula changes. but it remains the same. Currency and Futures options replace variables of this equation. Δ. gamma: measures convexity OR change in delta. always > 0 Written by Colby Schaeffer 8/17 .t stock price change Delta is the only Greek that you are expected to compute Δcall = e-δt N(d1) Δput = e-δt N(-d1) Δcall = Δput + e-δt *Delta of a stock is always equal to 1 Г.MFE Study Guide Fall 2007 Chapter 12 – Black-Scholes model The Black-Scholes formula is a limiting case of the binomial formula for the price of a European option.5σ 2t σ t d2 = d1 − σ t Contrary to other forms of the d1 equation that you will see. C = Se−δ tN(d1) − Ke−rtN(d2 ) P = Ke−rtN(−d2 ) − Se−δ tN(−d1) Where N(x) is the cumulative normal distribution function Assumptions/Properties • returns on stock are normally distributed and independent over time • volatility and risk-free rate are both known and constant • future dividends are known • there are no transaction costs/taxes Currency Options Replace stock price with currency exchange rate and the dividend rate with foreign risk-free rate – known as Garman-Kohlhagen model Futures Replace stock price with forward price and the dividend rate with riskfree rate.r. taking all other inputs as fixed. delta: option price change w.

. where the value is (S/H)x h1 = lower value of x. time to maturity change. + for put The Greek measure of a portfolio is the sum of the Greeks of the individual portfolio components Elasticity • tells us the risk of the option relative to the stock in %terms S∆ Ω= C For a call Ω ≥ 1.t.for call. rho: sensitivity to discounted strike price. theta: option price change w. usually < 0 ρ.MFE Study Guide Fall 2007 Vega: tests if volatility is sufficient. psi: sensitivity to discounted stock. and h2 = higher value of x Calls S  Value: (H − K )   H  h1  h  Maximum H: H * = K  1   h1 − 1  Puts – just reverse H and K and h1 and h2 Written by Colby Schaeffer 9/17 .r. . always > 0 θ.5σ 2 )x − 2r = 0 Each x value is the present value of 1 when a stock of value S rises or falls to price H. + for call.for put ψ. while for a put Ω ≤ 0 σ option = σ stock | Ω | Risk Premium: γ – r = (α – r) Ω α −r Sharpe Ratio: σ Perpetual Options σ 2x 2 + 2(r − δ − 0.

volatility. Rather. Overnight Profit OP = C 0 − C1 + ∆(S1 − S0 ) − (e r / 365 − 1)(∆S0 − C 0 ) Delta-Gamma-Theta Approximation *Delta and Delta-Gamma approximations are contained within the formula 1 C (St + h ) = C (St ) + ∆ε + Γε2 + h θ 2 Where: ε = St + h − St Black-Scholes formula This is different than the Black-Scholes EQUATION that was used for pricing options. stock price. and risk-free rate.i ) = (S 2σ2Γh )2 2 rC (S ) = Written by Colby Schaeffer 10/17 . 1 2 2 σ S Γ + rS ∆ + θ 2 1 Var (Rh . so they use delta hedging as a method of controlling risk. this equation is a function of the greeks.MFE Study Guide Fall 2007 Chapter 13 – Delta Hedging Market makers want stable portfolios.

variable annuities. pays off only if the option asset outperforms the asset it is being exchanged for Volatility depends on both assets: σ = σ s2 + σ k2 − 2ρσ sσ k Written by Colby Schaeffer 11/17 . Rebate – fixed payment if asset price reaches barrier Knock-In + Knock-Out = Standard Option Compound Option – option whose underlying asset is another option that expires later Compound Option Parity x: strike price of compound option t1: expiry of compound option t2: expiry of underlying option CallOnOption – PutOnOption = Option − xe−rt1 Gap Options – option with trigger K2 (price that option must be exercised) and strike price K1 that differ. Knock In – option “comes into play” if price reaches barrier 3. election is not optimal… Use K1 for put-call parity Exchange Options – lets you receive an asset in exchange for another at time T. and reducing volatility Geometric(S) < Arithmetic(S) Barrier Options – payoff depends if price of asset reaches a barrier level • payoff and option premium is less valuable than those of standard options 1. Knock Out – option goes out of existence if price reaches barrier 2.MFE Study Guide Chapter 14 – Exotic Options Fall 2007 Asian Options – based on the arithmetic/geometric average of underlying asset/strike price *useful for hedging currency exchange.

5 2 (dS )2 + dt δS δt ∂S Multiplication Table dt dZ dt 0 0 dZ 0 dt Written by Colby Schaeffer 12/17 . Z(t + s) – Z(t) ~ N(0.MFE Study Guide Chapter 20 – Brownian Motion & Ito’s Lemma Fall 2007 Introduction of terms 1) Stochastic process is a random process that is also a function of time. Z(t) is continuous dX(T) = α dt + σ dZ(t) X(t) = X(a) + α (t − a) + σ t − aξ σ: volatility or variance factor α: drift factor Ornstein-Uhlembeck Process Variation of Arithmetic Brownian motion… dX(t) = λ (α − X(t))dt + σ X(t)dZ Geometric Brownian Motion d ln[X (t )] = dX (t ) = α dt + σ dZ (t ) X (t ) 2 )(t − a) + σ t − aξ X(t) = X(a)e(α − 0.5σ Ito’s Lemma δC ∂ 2C δC dC = dS + 0. 2) Brownian motion is a continuous stochastic process 3) Diffusion process is Brownian motion where uncertainty increases over time 4) Martingale is a stochastic process for which E[Z(t2)] = Z(t1) if t2 > t1 Arithmetic Brownian Motion Z(0) = 0. s).

MFE Study Guide Fall 2007 Sharpe Ratio α −r = “expected return per unit risk” σ dS1 = α1S1dt + σ 1S1dZ If AND dS2 = α 2S2dt + σ 2S2dZ THEN α1 − r α 2 − r = σ1 σ2 Written by Colby Schaeffer 13/17 .

MFE Study Guide Fall 2007 Chapter 24 – Interest Rate Models A stochastic interest-rate model that assumes a flat yield curve cannot be arbitrage-free.T ) = a 2 σφ σ r =b+ − a 2a φ: Sharpe Ratio r : yield to maturity on infinitely lived bond These are fairly extensive formulas to memorize. so r can goto infinity • volatility is independent of interest rate Rendleman-Barter Model: dr = r α dt + r σ dZ (similar to Geometric Brownian Motion) Problems: • drift sends the interest rate to infinity Vasicek: dr = a(b − r )dt + σ dZ Problems: • volatility is independent P (t .T .T )r (t ) A(t . Skip it if short on time or space in your head. Arithmetic: dr = α dt + σ dZ (similar to Arithmetic Brownian Motion) Problems: • r < 0 is possible • drift is positive. Cox-Ingersoll-Rand (CIR) Model: dr = a(b − r )dt + σ r dZ CIR yield to maturity formulas are too much for an SOA exam which says a lot. but there is no way around it. Written by Colby Schaeffer 14/17 . Model doesn’t have problems like the other models have… “Mean reversion” prevents interest rate from going to infinity. r (t )) = A(t .T ) = e r (B (t .T ) +t −T ) − B 2σ 2 4a (1 − e −a (T −t ) ) B (t .T )e −B (t .

Length of contract Caps & floors control risk and promote parity. caps are like calls and floors are like puts. Unless given.MFE Study Guide Fall 2007 Interest rate models allow us to generate stochastic yield curves. Value bonds and options just like we did before. Written by Colby Schaeffer 15/17 . Caplet values are equal to the difference in the strike rate and given interest rate at a node multiplied by the notional amount. Types of Options 1) Calls/Puts – American/European 2) Caps/Floors a. Pricing follows the same method as binomial interest rate trees. but it MUST BE DISCOUNTED AT EACH NODE due to varying interest rates. Notional Amount c. Binomial Interest Rate Model All that is needed is a tree with short rates and p*. assume p* = 0. Black-Derman-Toy Model BDT Model is actually not that difficult. Frequency of Payment d. but the models themselves may be too restrictive.5. Simply. Strike Rate b. It is an binomial evaluation of the yield curve calibrated to actual results.

strike in PC parity Exchange: Volatility depends on both assets: σ = σ s2 + σ k2 − 2ρσ sσ k 16/17 .5σ 2) + σ h 2) −σ h d = e (r −δ− 0.P = B0 – = PV[Ft.T – K) = x0e-r€T – Ke-rT = S0 – PV0.T(S) .Ft. K. T – t) > St –K u ≥ e(r – δ)h ≥ d At the prices Sh = Su.P = PV(FO.5σ Schroder’s Method F = S – PV(Div) S σF = σS F Path-dependent options Asian – based on average price Barrier Knock-In + Knock-Out = Standard Option Other Exotic Options Compound CallOnOption – PutOnOption = Option − xe−rt1 Gap: use trigger in d1. a replicating portfolio will satisfy: δ (∆ × Su × e h ) + (B × erh) = Cu δ (∆ × Sd × e h ) + (B × erh) = Cd Black-Scholes Pricing ln(Se−δ t / Ke−rt ) + 0.T(Q)] Risk Neutral Probability (of increase in stock) e( r −δ ) h − d p = u−d * u = e( r −δ ) h+σ d = e ( r −δ ) h−σ h h Early exercise is not optimal if: C(St.5σ 2t d1 = σ t d2 = d1 − σ t C = Se−δ tN(d1) − Ke−rtN(d2 ) P = Ke−rtN(−d2 ) − Se−δ tN(−d1) Option Greeks Δ = e-δt N(d1) Elasticity S∆ Ω= C σ option = σ stock | Ω | Risk Premium: γ – r = (α – r) Ω α −r Sharpe Ratio: σ Overnight Profit OP = C 0 − C1 + ∆(S1 − S0 ) − (e r / 365 − 1)(∆S0 − C 0 ) Written by Colby Schaeffer Cox Ross-Rubinstein u = eσ h h d = e −σ Lognormal u = e (r −δ− 0.T(Coupons) – e-rTK Different Assets: C .P C . Sd.T(DIV) – e-rTK C .MFE Study Guide Fall 2007 MFE Equations Sheet Put-Call Parity General Formula: Currency: C-P Stock: C-P Bond: PV0.

5σ 2 )x − 2r = 0 S  Value: (H − K )   H  h1  h  Maximum H: H * = K  1   h1 − 1  Vasicek: dr = a(b − r )dt + σ dZ Cox-Ingersoll-Rand (CIR) Model: dr = a(b − r )dt + σ r dZ Black-Derman-Toy tree X(t) = X(a) + α (t − a) + σ t − aξ X(t) = X(a)e (α − 0.MFE Study Guide Fall 2007 Delta-Gamma-Theta Approximation 1 C (St + h ) = C (St ) + ∆ε + Γε2 + h θ 2 Where: ε = St + h − St 1 2 2 σ S Γ + rS ∆ + θ 2 1 Var (Rh .i ) = (S 2σ2Γh )2 2 rC (S ) = dX(T) = α dt + σ dZ(t) Perpetual Options σ 2x 2 + 2(r − δ − 0.5σ 2 )(t − a) + σ t − aξ Ito’s Lemma δC ∂ 2C δC dC = dS + 0.5 2 (dS )2 + dt δS δt ∂S Ornstein-Uhlembeck Process Variation of Arithmetic Brownian motion… dX(t) = λ (α − X(t))dt + σ X(t)dZ Written by Colby Schaeffer 17/17 .

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