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    ASM MFE Manual Ninth Edition PDF

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    © All Rights Reserved
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    Contents 1 Putcatt Party 11 Review of derivative instruments 112 Galland put options 112 Combination of options 12 Pateall parity 121 Stock peal party 122 synthetic sock and Teasories, 123 synthe options 124 Exchange options 125. Curreney options Everlee Salton pmparing Options 21 Bounds for Option Prices 22. aly eeriseo! American options 23 Timetoexpry 241" Thee inequaes «. 242 Options in themoney Exercises Solutions |S Binomial Trees Stock, One Period 31 Riskeneutl pricing 132 Replicating portalo 33. Volt. Solitons 4 Binomial Tees—General 41. Mul-period binomial woes 42 American options 43. Curreney options 44 Futures, 43 Otheresets Bxereises Soltis 5 Risk Neural Pricing 511 Picng with Tre Probabilities 52 Rlk-Neutal Ping and Uilty rercies Solutions w conmENTS 6 Binomiat Tres: Miscellaneous Tops wz {1 Understanding early exres of options. ‘ 7 62. Lognormaltyand alternative tees 1 82:1 Lognormalty eee I es 622 Aemasve res 19 63 Banat olay = cca 130 Baercises i salons = : : eae 7 7 Modeling Stock Prices with the Lognorma Distsibuion 7A The normal and lognormal dvtbutons «+. 71 Thenormal distin : 712 Thelognormal distribution é 713 Jensen inequality 72. Thelognormaldntbution asa model or stock prices 721 Socks without dvgends 722 Stocks with dividends 723 “Confidence intervals" : 78. Conditional payos using the lognormal model eresee ae Solutions © 1 ing tock Prices toa Lognormal Disibution 181 2 Evdhngtheerphialy to Solitons ein 9 "The Black Scholes Formula ra 5.1 Black-Scholes Formula for common stockoptons ve S12. Black-Scholes forma or cureny options : : ” 93 Hack Scholes formula for eptons om ates ve rie : : Lue Saltins i 10 The Black Scholes Forme Gree 191 101 Grete im {Lt Beka : vse 1012 Gamma! a 1018 Veen z : 17 1014 Thee, 198 1013 ko ame 1018 Pa. ae 1017 Gromesses for portion ere 2s 102 Hay snd ltd concep ne 1021 Estey = ee peed aoe 1022 Related conopis See an 1023 Basti ofa porto an 10.3 What il Be teted ont ae Exereies ° 23 solutions : TEED ai ONTENTS: 11 The Black-Scholes Formula: Applications and Vola 111 Profediagrame before matty LLL Calloptions and bull spreads : 11.12 Calendar spreads 11.2 Voie : . 112.1 Implied volatity 11.22 Hlstrel volatility : series Solutions ae 12 Datta tedging 121 Overnight proton adel hedged portolio 122 The delta-gamme-theta approximation 123 Greeks for nomial ees Peee 124 Rbedging eee 125 Hedglag mutipe Gres ee 126 Whatil betestedont | sss vss ss Exercises : Solutions mo 13 Asan Barver, and Compound Options 131 Asan options 132 Barer options 133 Maxime and minima. 134 Compouncl options. 15.11 Compound option pity 1342 Amercan options n stocks with one discrete dividend 1343 Bermudan options : rerio vos : Solutions ae 14 Gap, Fachange, and Other Options 141 All-ornotlng options ea 142 Gapoptions ; 1421 Deion of gap options eee 14.22 Pricing gap options sing lack: Scholes é 1423 Delta hedging gap options 149 Fxchange options wns : 4 Other exatie options : : 114.41 Choose options. 1442 Forward tan options yereises Solutions oe 15 Monte Carlo Valuation 15.1 Introduction 152 Generating ogaotial random numbers =. 133 Simulating dervative instruments - 154 Control variate mathod : 155 Other variance reduction echniguee Brerises : ee escite teeen 2m S888888 ESSRSRRESESE SERRBRSRSS SRERRATES SEseE conrents Solutions 3m 16 Brownlan Motion a0 161 Brownian motion ean 162 Aitkmetie Brownian mation. ‘0 162 Geometcie Brownian motion. : aa Berises eran ‘ 85 Solutions a 17 iferentals 309 174 Ditfereniatng a ae 172 Thelanguage of Brownian mation 1 Solutions ates : 95 18 1stemma 399 rerlses cece a Soluons 2.020002 08 19 The Black-Scholes Equation a Sotudons 2.21. ae ce ena as 20 Sharpe Ratio 42a 201 Calulating and using the Sharpe tio cece Hh 202 Risk ree Portfolios 2 sotuons 222. 3 21 Risk Neutral Pricing and Proportional Portfolios an 211 Riskenoutl pricing “1 212 Proportional porto 43 verses M6 sohaons us 221 \aluing forward on * ea ‘ : ae) 222 Thelto process for" ea aa 223 Derivation af iy (S)wsg ue peeing Paes 45 22: Examples ofthe formula fr forwards on S* 455 eee ta 60 23 Stochantie Integration 07 21 Integration aan “67 23.2 Quadratievaiation : St 168 24.3 Diferenil equations : eee al Baereises cal Solutions 22. a a teste 24 nomial Tre Models for interest Rates 241 Binomial Tees 22 The black-Derman- Toy model 242.1 Constuetion of flack-Derman To binomial tice 2422 Pricing forwards and caps using 2 BDT cee Solon 25 The Black Formula for Bond Options 26 Equilibrium Interest Rate Models: Vasleek and Cox-ngers 251 Pricing Options with he Black Formula 252 Prcingeaps wits he Black forma Brerciss ‘Solutions 281 The impossibve mode! 282 Rguilbrim models 2821 Thetendleman Barter model 2622 The aseck model 2823 The Cox ngereal-Ross model 283 Characteristics of Vasiek and Cox Inger oss models 263.1 Risk-peatal pring 2532 ale, T}e®™" form DAA R(T} (Valen made) 25.14 Shaipe ratio questions 2535 o0/07 26.16 Yield on infield bonds 264 Deka hedging Solutions Practice Exams Practice Exam 1 Practice Exam 2 Practice Bxam'3 Practice Exam 4 Practice Exam s Practice Exam 6 Practice Exam 7 Practice Exam 8 Practice Exam 9 aces so. ot 10 Practice Fxam 10 1 Practice Exam 11 Appendices [A Solulonsfor the Practice Exams Solutions forPeatice Exam Pees . Solitons fr Practice Exam 2 Satins fr Practice Exam 3 Solitons for Practice Exam 4 Solutions for Practice Exam 5 Solitons for Pract Exam & Saline fr Practice Exam 7 Solitons for Practice Exam 8 Solutions for Practice Exam 9 Solution for Preece Exam 10 ‘Solution for Practice Exam 11 Solutions to Ola Fxams [LL Solos SOA Exam MEE, Spring 2007 182 Soltis to CAS Exam ,Sping2007 =. 1B Solulns to CAS Bua 3, Fall 2007 : 14 Soltione to Gram MPE/3 Spring 2008 [BS Soludans o Sample Questions Lessons Corresponding to Questions on Released and Prats Exams Standard Normal Distribution Function Table Preface Welcome tothe MFE/3F exam! ‘The SOA is developing a new Risk Management cedental, CERA.Stadents can qualify for this creden tial without staying Life Contingencies. To make thi posible, tis exam wat spl of fom Exam MIC in Spring 2007 The CAS decided to jon the SOA an olny Sponsor his exam bening fn Spring 208, ‘You willbe studying, almost exlusivey option pricing There wil be shor discussions of forwards here and there, but almostall ofthe de you wl be pricing calls ad pts You may have encountered asi norman ‘on these when you took Exam 8/2, bt you dont need eveything you lerbed in that course. Abit summary ‘of theinformation you needisgivenat the beginlngar Lesson 1. The restolthe course can then be dived i ‘the elmentarypart~Chapters 914 and 18-19 fom the textbook, covered in lessons I-15; nd the advanced ‘part—Chaptes 20-24 fom the testboo, covered in Lessons 16-25. The elementary par oes the flowing order 1. Principles relating pices ocallsnd pus, and relating pices of options o each ater and bounding thet, ‘These principles donot develop exact pices for options, but are general and easy to derive 2, Valuing opcons using binomial ees, 3. Valuing opons using analyte methods (lack Scholes. 4. Doinion ofexoe options, and pricing methods where avalable 5. Thelognormal modal for stocks 6. Monte Cal valuation, ‘The advanced pat covers: 1. Theory behind valuation formulas: Brownlan motion, lems 2. Valuing options on bones interest ate modes. ‘The MeDona textbook ian easy read forthe elomencary part, but becomes more difcltfor the advanced prt I est avoid higher mathemas. Asa esl willoften skp steps int decvation of formulas Iealso testo develop diferent formula null, which doesnt always make them eas toundertand found the ‘material in Chapters 20-23 (wher to proceses ae discussed) an the beginning of Chapter 24 wer nest rate models are dscused) particulary eificat. These chapers ae extensively covered in Lessons 16-29 and ‘Many ofthe textbook endo chapter problems ae wort looking at. Howeve, many depend on spread: sheets provided with the textbook. Onan exam, you wil nether be given those spreadsheets nor allowed use Bice, you us the textbook, refer othe following website fr erat forthe fst printing: beep: / aww ettogg. northnes ern odu/faculty/edonsid/sta/typoe29_01.Atal or for ecratafor the socond printing (which includes ational erat forthe fs printing dneep://iw, kel ogg. norvhgestern.odu/faculty/acdonad/bts/typos2e,02. heal ‘Table 1 shows the welghts given wo diferent topics on this exam inthe CAS syllabus and on the SOA sam ple an he released Spring 2007 and Spring 2009 exams. The non-sylabus question i on Perpetual Options. & PREBICE “Table 1: Distribution of exam questions Namberofauestions os Sar Tentont | nua! [png [TP Sane] Sonne |S Tope Chaps [isons | 200" | zor | quetons | sur” | Eon veweatpiynde | 9 laa] a|sl s [a] 2 | ed ert 2.dinoma es wu fos | afal ae [a] s 3. Lognormal model 18 cy o o 3 o o] ‘hak Sele wv fen} ofa] a fal 3 5D dng we fie] afta] s fala 6. resins uw fou] i fa] oa | a | 2 TMoneaowuain | ts | is | o | o| 's | o| o topcase wa fwn| i }ol a | 2 | 6 Sineearemoats | at” | zen] 2] o| 8 | 3] 3 Noronytabue Loteo| «tila eal Gea Sea apa Material in Lessons 7-8 and Lesson 15 was added tothe syllabus forthe Fal 209 sting and therfore does not appear on thecalereleased exams. According the bus, 65-75% ofthe exam willbe on tpl 12:8,and 8 of able I: 5-10%an ope 10-15% on ople7 and 10-15% on pies (Curent the ME/S¥ exam is 23-hour exam and shat 90 questions, incadng plot questions, On com: puterbased tests pilot questions are questions that are not graded. Instead, thee dfculy is assessed based ‘on how well stdens do on them, so hat the pass mak on exams wih hose quenons consent with other ‘administations However, the exam was about 20 questions before Fall 203, and wes about 2 questions fom Fall 2009 nt Fall 2020. Wit gard to the SOA sample questions, note that questions 1-16 were not on any exam. However, some ‘of questions 17-30 and some of the later ones, according to stodent reports, were on unreleased exams. 1) patcular, 19 and #22 vere on te Fall 2007 exam (and possibly oder questions inthe #17420 range), wile 12), #23, 425-09, and #47 were on the Spring 2008 exam. Also, question #48 was onthe Fall 2008 exan, and ‘questions #50-¥82 were ken from the Spring 2007/4 Exam, and question #61 is sad to have been on the "2009 exam, Many ofthe questions ater #64 also are similar to student reports rom unceleased ears While ‘the sample questions largely come fom pas exams, they are probably the harder questions fom hose exam ‘the overall dificult ofthe real exam sess than that ofthe sample questions. While te el exam puts fally Ineay weight on tb processes, my gues Is that you should expec questions (or about 20% of the exam) on tp processes, nt the rato implied bythe sample question dstibuson. The dstbution ofthe Spring 2000 ‘xa, adjusted forthe adltion of new topes, is probaly more nda of the distribution of exam questions. ‘he CAS exams virally skipped Brownian motion and interes rate models, and the fer questions they posed on these topes on their Spring 2007 exam seem to indieat lack of experts In thelr eam commie. The disbutio of topics and dificltyof questions onthe CAS exams not ndtv of tae exams. os Presace a This manual This manual gvesyou compete coverage ofalsyllabustoples.T help youcheckhow mich you ae sbsorlng, ‘thor are quizes wih euch lesan; these are sraightforunrd exercises which you should work out at you get to them. Solutions to quizes are atthe end ofthe leon, after the sluion to the exercises, The execlees a the en of each lesson are designed tobe exaike (although sometimes they ae abit ong fran exam), ‘equing only eaeulatorand. abe ofthe normal disebution to solve. Working these out wll help you learn the concepts. "Natethe lowing valuable featres at heen ofthe anual: + Solutions o relevant questions rom all leased exams: he Spring 2007 and Spring 2009 Exams MEE and ‘the Spring 2007 an Fall 2007 CAS Exam 3 + Solutions to the 76 sample questions. The solutions provided by the SOA ar longer and often include ‘tional commentary and educational material My solution gett the point and are meant to ndate ‘he method yout use onan exam + Across reference indicating the lesson covering every relevant question fom the release exams andthe sample quessons and asl crss-eferenceforalqestons inthe twelve practice exams. + Anindex Anote on notation: the MeDonald textbook uses N(x] indicate the cumulative standard normal distrib lion at. Many other textbooks use Mfr the same concept, andi fat Tuse (2) inthe Exam MLC 3, and (C/4 manuals: However, fortis course, Ifllow McDonald and nancial economies tration and se Ns). New for this edition ‘Siificant now features inthis edition a= 1, Allcalculations involving the normal distribution have been redone in accordance with the precision of the neve Prometric eal, 2, 5 new eereises on various topes, neuding 1 on interest rate models, were added, 23, Lesson 26 was organize, 4, Duplicate and detective practice exam questions wore replaced The normal distribution table ormulsin this course use the normal disbution. Most students wil be aking this exam a Prometze se, Prometric provides standard noma disrbtion calalton. See htp://ww.pronetric.coa/SOh/MFESF calculator hem to see how this works, The calculator provides values af the cumulative noel distribution function and ts inverse to deta places "when working problems in this manual, you may ces HORASDIST and NORNSTNV functions to perform normal distribution eaeulatons in a manne similar othe way yu wil do them on an exam. Arora it bation table is provided in Appendix D, You cat use thi ina pinch if you dont have access (oa caleuatr oF rogram tat can ealalate norma distribution vals, Tnadditon, you willbe given formula sheet. See x -ntep://wwe,promatric.coa/SOA/MFESF_calculetor.nex {or tis sheet. 1 provides the standard normal density funtion, dhe lognormal density function, and moments olthelognormaldxsibtion, you are aking the exam at a paperand-pene se, you wil be given formula sheet and «cumulative normal distribution able, Cacenthy the ul for this tables hep: //aw.s0a.org/tilea/pat/odu-2009-fa11-nfe-table.pat ‘The formula shoe has es for the use ofthe abl, aden hat You should not interpolate inthe abe se ound vals Rea those ales for more deals ‘Since moe students il be taking the exam under CBT, the man uses the more exact method of elu lating normal distribution values, namely pace precision, Errata Please eport al errors you find in these notes to the author. You may send thom to the publisher at ma2.2 studymanuals.com or drectyo meat erratadaceyourexans.net. Please ideal he manual and eon {he ezor sin. This the ninth eiion of the Fxam M/F mans “Aneraalistwilbe posted at errata. aceyourexans net. Check this eras frequent Acknowledgements "woul keto mank he SUA and CAS tor allowing me to use questions Hom ther ld exams, The creators of FX, BF, adits mullite of packages ll deserve thanks for making possible the profes: sonal ypesting of hismathematical materia. Tish acknowledge all tudents who sen in erat or recommendations for improvements, whether many or few. Special thanks to Jeff Raven fr his mathematical sighs. "paral at of other suerte wt pointed ot exons Mak Aan Ryan Amma, El Barich, Ease Bal Be ‘any Barer, Andie Tl Eu Shen Berman, El Bochner Nichols Brae. Kon Burt, Yang Can Mell Car Jet Cet Garand Can Grace Chang, Aaron Chas. Biy Cen, Fling Chong Ae Cho an Chung, Sve Cla, Douglas Cat, Su Cts: Thomas Dat Cameron Daniel aie Oui, Lindby Daniels Magdalena Died atk Di flit near Dana Dor Bryan Donker, Ades x Peso Eon fal, Mather, ‘cheved pra, Matthew Ets, jeremy Evans, oe Faure, tons Frog Amara Felner, Yucog Fe Dane Fer ander Flinger ce Fr. ce Ga Georges Ghana, Aryeh Gch, rt ibn, Micha Golsen, Tovah Gracy Tvs Greeley Gay Aison Gut, Dvd Hamann, Aaron Hahn, Seat Handley. Fyn es, Witlam Henderson. enn Ho, Spmphone Home, Susen Home, Steps, Set Humes, Cala Hvar, Doyen sng tie ler lng, Dee nse, Mate enc, on lag Sewn Jones yon ang, Derek kash "rank Ky Prec Koppelman, Rela Rtste Ante Kyo, ako Ranazaa, Deke Kung Jacqtne al, Sex [stone Gry Laan, uc! Lata An Le, Domini Le Jneph Seung re Yok Le, Yong chor Leas Lng, ‘Chass Lindberg David Li, vy La, son Mack Wison Ma Ces Mave, Cpe Macc ron Masri ‘com Ras Mawk ein Mebith, Stat Mcroden ate Meow linny bce, hip Mekeran sep Malt, Pu Mollena Lag Muti Csiopher Nes Eat Nas, Bet Ne Nb. ome Oka, Ar Oars Pte ‘George a xn Peas, Stang Pg Cole Se Peter Kn Ming hon. Amana opbam jun Pb oa Pre, Tad emits lara Ryne, Va Sura Dai Schenck, Dem Schobel Simon Ser rn Shige: David Sune, Ch Ses Ca ‘Sion, Core spas, Ro teat, Alon Stoop. fseSultg, cols Sundsad me Swanson, Susan Spans hoon Te, Georg nnn Suan Thoma Nan lan Shel Tula, Teens Ta Mayer Tolan Leon hah ‘oppor Sam Teng aul Uh, Vege, Edward Wang Kae Hen Wang, Cars Washou Leighton Nese, Cet ‘Wal Kt Vilma, amie Wong, ctor Wong, Wood Karla Wysal Ere Yes, ode a, Bai ance Dee “nein, sion Yuen, Ben Zag, Aron Zeige, Cheng Zang. Soy Zang "ial ike othank Presi Kzysa Ostasrwsi fr pling oan er Lesson 1 Put-Call Parity Reading: Derivatives Markets9.1-9.2 ‘expect one ot more exam questions base on hisleson, 1.1 Review of derivative instruments ‘This review section will not beet tested on. Ils background mater fom Exam F/2 that you are ex pected to already know Ifyou donot wish to eew, proce immediately to Section 1.2, page 10. 1.1.1 Forwards ‘forward ian agreement o buy something a future date for a certain price, We wll se the notation Ft Indeate the price tobe pad atime T na forward agreement made atime ¢ to buy aa em tte 7. Notice ‘hat no payments made at time ftheonly payment made Isa time T. Ifyou purchase forward on stock at time f, you wil pay atime Pand ect the stock. In pretice, there my be no physical transfer ofthe stock. tat, stent nye weve by yt receiving the difeencea the pica the stockat time Tand Fi Ifwe tS be the pic ol te sock at ie then you would receive Sr ~ Fy which may be postive or negative. Ths he payois linear function ofthe ‘value ofthe stock at me 7. Suppose we assume Fir = 0, Ife stock price atime T Is 30 you then pay 10, TF the tock price a time 750, you then receive 10 The paso atime T asa funeson ofthe stock price atime T.Spisshown in Figure 11 ‘forward agreement sa customized comet. tures contac, n contrast, fea standardized exchange traded contract whch is smart a forward in that isan agreement op acertan amount atime Tora ‘certain ase. However, atures contac s marked o market dala pal of ts value is made berween the parts each day. There are oer differences between forwards and futures. Howeves, inthis cours where We ‘ve only interested pricing ther, we wil not dietenite between them. Payoh 0 2a] | a ee eee Figure 1.1: Payot on 2 forward having price 40. The payoie Sr~ Fir, where Fr = 40 Nesey etn 1 Speoreaae 1. PUECALL PARITY Let us determine Fz. As we do so, we shall introduce essumpdons and terminology sod throughout the cours. One assumpdon we make throughout the cours is that there rikfee interest paying investment fan invesoment which wll never default. you invest X in this investment, you are sure wo recave K(L+1) at ‘he end ofa yar, where is some interes rte We wl always express interest a a continvosy compounded ‘at instead of as an annual effective rate, unless we seyatirwase. We will use the ltr or thi at. In Financial Mathematics the leer 6 i used for ths concept, but we wl be using 6 fora diferent (although ‘elated concep, Ar you Teared in Financial Mathematics +e". Soifthe ike effective annual etn ‘sas we woul say that r =n 1.05 = 0.0479 rather than OS. In elif, Treasury secures play the role of ikffe interest paying investment Here are the assumptions we make: 1, Ieispossibteto borrow orlend any amount of money at he risk-free rat, 2, There ate no transaction charges or nes 8. Arbiragesimpossibie ‘An Aritragesa set of wansttions which when combined have no cost no poss oflss and at east some possibly ifmo certain) of pro In order to make arbitrage Impossible, there are two sets of transactions Teslng the same end rest they mist both have the same pie since othervse ys coud enerimocane set of wansactions asa solr andthe other set as buyer and be assured a profit with no poss of ss Forwards on stock ‘We wi consider posses ror me stack: 2, The stock pays no dividends 2, The stork pays disrete dividends 8. Thestock pay continuous dividends Forwards onnondlvidend payigstock ve begin with forward ona nondividend paying stock. The onan agreement entered atime O and provides for transfering the sock at time T. Let, be the price ofthe stock time f. Thee ate two ways you can gum the stock ime 7 ‘Two Methods for Owning Non-Dividend Paying Stock at Time T Method, Ruy stocka ime 0] Method 7: Ray fora on woe ‘and ha ioe T ‘ttime and hold ito time T Payment ine O Se 7 Payentatiime 1 a Tir -ythe principle of no aria, the rwo ways mst have the same cos. The cosa tie O ofthe ist way is ‘othe price of the stockat cine, The cost othe second waylapayientof Fy at ne Since youcan Invest at the isk reat, every dela invested at ine O becomes e”” dollars at ine T. Youn pay fy at time Tby Investing Fre"? atime 0. We thus have Brea! _Wehave priced his forward agreement. Ld, REVIEW OF DERIVATIVE INSTRUMENTS a Forwards onastockwith discretedividends Now let price a forward on advdend paying stock This means Iepaysinown cash amounts at known times There are the sametwo ways to own aock atime T: ‘Two Methods for Owning Dividend Paying tock at Time T “athod Ws Hey sackat time 0 Method ¥: Rayos on oer and hold it totme atte Dd hold ittodime 7 Ppmearaeine o s o 7] Paymentattime 7 2 cs However you use the fist vay, you wil aso have the stock’ dividends accurate with interest which you wont have with the second way: Therefore, the price of the second way a of ime T mist be cheaper than the price ofthe ist way aso ime Tby the accumulated value ofthe dvigends. Equating the? costs andleting ‘Cunalue(Di be te accumulated value at ne Ta dividends from te Oto time T, we have fr ve"7 Oumahu(Di») an Forwards on stock index with continuous dividends We wll now consider an asset that pays dvdends at ‘continuously compounded rate which ge reinvested in te att. In er words rather than being pd os «ash dividends at certain times the dividends get envesein thease continously ott te lnvstr ends ‘Up with adalional shares ofthe asset rather than cash dividends. The continuously compounded dividend rate willbe denoted 5 ‘This could bea model for astockindex stock index consists of many Rocks paying dividends various ‘umes Ase simplifcauon, weassume thew dividends ae unifor, We wlloften model single stork not jus a tok index, fi had continuous reinvested dividends, using 6 instead of epic dividends Lets price forward on astock index paying aiden at ate of, Kyou buy the stackindex at ime and ‘pays continuous dividends atthe rated, you wil have 2°” shares ofthe stckindexat me 7. Torepleate this with Forwards, since the forward pays mo dvidends you wold noed to ener ora agreement to purchase 1257 shates of heindex. So here are two ways to ow shares ofthe stock index at time ‘Two Methods for Owning o*” Shares of Continuous Dividend Paying Stock Index at Tne 7 athod 0: Ruy sock index at | Method #2: Baye” fords on time Gandholditionme T | stockinderat time Dand hold t0 time T Papmentartine 0 = 7 Paymentat tine 7 o ra Thus to equate the two way, you should buy 2” uns ofthe forward at time 0. Aime The accumulated «cost of buying the stock index at med 6 Se" wile the cos oe” uns ofthe formal ageement Fare", cowehave Bre Bra syelO 02) ‘We ee here that andr work in opposite directions. We wil inn goneral that tends to workike a negate a bens 1. PUTcALL PARITY (Quiet *Forasioak you are given © pays quarry avidends F020, (i) tehas st paid a avidend (Gs prices 0. (i) Theeontinoously compounded risk-free interest ati S%, Calculate he forwanl pric for an agreement ro delve 100 shares ofthe stock sik months from nove "forward on a commodity works much ike forward an a nondvidend paying tock. Wf dhe commodity produces income for example you can eset ou, the income play the rol of vdend: ie eommodiy roquires expenses for eample, storage expenses), thes expenses Workke a negative dividend Forwards on currency For forwards on cureney, tis assumed that each currency hs sown rte interes rate. The ike terest ate forthe foreign curren play the role ofa continuously compounded dividend ona stock Tor cxample, suppose a forward agreement at ine 0 provides forthe delivery af eos for dln time: ‘Let be the skew ate in dollars ad re the skeet In euros. Let xy be the rate atime. The two ‘waysto ave euro aime Tae 1. Buy e-7 eurorat ge O and et them accumulate toe F. 2, Buy forward for | euoat time 7, witha payment of Fr atime 7 “Te mrs way coss ze dolar at ume o-The second way can be funded in doa ar ume Uby puting aside fe Fr dallas ate 0. Thus eM Reane Be ‘Quie 1-2 A yen-denominated forward agreement provides forthe delve oF S100 at te end ofS months The continuously eompounde rik-re rie for dolla s 5%, andthe continuously compounded sk fee at or yen s2% The curent exchange rates 1104/. Calculate the forward pice in yen or this agooment. ‘Asummaryofthe forward formulas sin Table. Thistable makes the easy generalization fomagiements ‘entered atime 0 agreements entered at timer Ieisalso possible to have forwards on bonds, and bond interest would play the same role as stock idends ‘nuh forward More typical are forward rate agreements which guarantee an interest rate 1.1.2. Call and put options ‘Aca option permits but doesnot requ, the purchaser o pay a specfic amount K a time Tin etuen for an aise. ha cal option, there ae two cath flaws payment ofthe va ofthe call option is made atime and ‘possible payment of Kn ern fran assets made atime 7. The payment ane , which the rei ofthe call denoted by CURT)? Atte T.rathe than actly paying K and receiving the asset a monetary Lanes si crc Nan hee om at ey ‘thts team am ots est pa bhai puns ogrtenr eee Li, REVIEW OF DERIVATIVE INSTRUMENTS 5 “able 1.1: Forward prices 2 time 1 for settlement a time T Undesving see Forward price "Non-vidend paying stock ser Dividend paying stock 50-9 Gamat) Siodkindex sie" ‘Gunency denominated in corency a | yg Fordativery ofcurency f i 20 0) ° ~ct00.7) — a se a — oe a (aor ett! ise onl open (0 Pst vmeton puter Figure 1.2: Pay net of initial investment (ignoring interest) on option with 2 sre price of 40 settlement ofthe diference usually made. Sy ithe vale of the asset a time T, te payottisman0,S;—K) The one who sel the call option scaled the rte of the call option "Aputoptin sthe counterpat toacal option. lpr, at doesnot equ, the purchaser to sell an asset ate Tfora price of K. Ths there ta payment at ine 0 ofthe premium ofthe put option and a possible ‘eceiptof Kinet forth asset at time F The payment atime 0, which the premium othe pus denoted {KT} The monetary setiementat time T ifthe assets then worth is aK, KS) ‘ctscaled the sre ple, gute 1.2 shows the net payoff of call ora put, assuming the srk pice is 40, The cost ofthe option tudded othe pay at theme 7 interests ignored although we wont gore when we price the option, ‘The options we have described are European options Buropean options can oniybeexeceed atime 7, nat before In contst Amerzanopionsaliow the option toe eerie at any ie up one 1.1.3 Combinations of options ‘Various strategie involving buying or selling moe than one option areposibe, These are discussed in chapes'3 ofthe MeDonald textbook ad you lear about them In Course FM/2. Is probably not necessary to Know aout them for his exam, since exam questions about them wil deine ther for you. Nevertheless, ete 3 Shor summary of them ‘When we buy X we ae saldo be long X, and when wel X, we are sid tbe short X: Long and short may he used as adjectives or verb. 1. PUT CALL PagETY Option strategies involving two options may involve buying an option and sling another option of the ‘ame kind (both alls or oth puts, Buying an option of one kid and selling one ofthe other Kind, or ying twooptions of diferent kinds (which would be sling two optians af diferent kinds from thes parspecte). We ‘wallbe assuming European option fo simply. ‘Spreods: buying on option ond seling another option of the same kind ‘An example ofa spread Is buying an opton with one strike pric and sling an option with diferent strike price Such spread is designed to pay offfthe stock moves none dection, but subject oat Ballspreads A bullpen pays ofthe stock moves up in price but subject to sit To create bull spread with als buy aK stk allan sella Kath call > Ky. Then at expiry time T, 1. iS & neither option pays 2. IK; <7 Ky, thelomer-strike option pays Sr~ Ki, whichis the net pay 3. MSp> Ky thelower-stke option paysy~K; and thehigher-suhe option pays K;, So thenet payott {athe diterence on KK. ‘To create bul spread wih pus, buy aK) strike pt and ella Ke-strike put, Ks > Kj. Them at expiry te 7, 1, IS ©, helower strike option pays K,~ Sr and the higher strike option pays K Sy. foranet pay of Keo, 2-18 2Sy5 Ky th were option is worthless andthe higher strike option pays Sto he net payors Sy ~ Ki. 8. Sr» Ks both options are worthless, ‘Although all he pays othe purchaser of bl spread wit pts are non-positive, they increase with ncreas- ingstckprice. Since the posion has negative cos (he option you bought cheaper than the option yousol), youl gun as lng asthe absolute vale ofthe net pays lower han the net amount recived at inception, And the absolute vale ofthe nee pay decreases as the stock pice Increases. ‘Adlagram ofthe pet profit on all spread isshown in igre I. ‘Bear spreads how spread pas off the stock price moves down in pice, ut subject oat. Toceste a bear spread with pus buy a Ke-srke put and sella K-strke put, Ky >. Then 1, Sy K; neler option pas 2, IK, > Sy 2 Khe higher strike option pays Ke 43. IfSy- Ki, Then 1. IS, 2 Ky, the higher strike option pays ~ Ke and the owersrik option pays Sy— Korat payotl oki Keo 2. If > Sp > Ky the higherstike option is worthless andthe lowersrike option pays Sy ~ Kj for amet payotfof Ks -S1<0. 5. IS Kj) and buying 2 bear spread of puts wth strikes Ky and Ry. This mens buying ad eling the following Bal Bear suite | spread spread %; | Buyeal separ | seteat_suypue Assuming European options, whenever you buy acall and sll a put at the seme strike price exercise by one ‘ofthe parties is certln (Unless the sock price & the strike pice a matursy in which eae bot optlons ate ‘worthless sos equlsalent oa forward. Thus a box spread consists ofan agreement to buy the sock for {and slit for K, with definite prot Ky ~ Ky. If priced eoeecty there wil be no ga o lose regardless of the ‘Stok peice at mati ‘Buttertyspreads A butterfly spreadisaree-option strategy all options ofthe samerype, consisting of buying ‘bull spreads with sce prices Ky and K; > Ky and sling m bull spreads with sik pices Ke and Ks > Ke, ‘with m and selected so that or eal ithe stock price Se expt greatr than X, the pays net to zero. (tps are sed, range eso thatthe pays are ze iS; < Ks) ‘ets workout the relationship beeween mand fora butt spread with all + For the. bull spreads which you buy with strikes Ke and Ki, the payo is Ke Ky when the expiry stock prices Ks > Ke> Ki 1. PUTCALL PARITY Net prot 20 10} ——————————— 0 w oe 70S Figure 1.4: Net profit on butely spend. European cl options with strikes 4, 50, and 60 are use + For them bull spreads which yu sll with strikes Ky and K, the pao Kj K, when the expr stock pees Ky > Adang up the pays UK Ki)= mK = Ki) ns — Ky) = mC) Inthe simplest caso, m = and Kis hal way between Ki and Ky this i a symmetric butter spread. Otherwise he buttery spreads aymmete ‘Tae payoonabuterty spreadis0 when >< K,Ithen increases with lope nuntlitreachesitsmaxmum ats =, at hich point ic np ~K)}- then decreases with slope mn reaches Oat Sy = Kya 60 focansy> Ks diagram ofthe net profits in Figure 1 There sno free lneh, so the options involved must be priced In such away tate buterl spread loses money the Hal tock price below Kyo above Ki. This implies that option prices as faction of stk prices must be conver, This wl be discussed on page 40 Calendar spreads Calendar spreads involve buying and selling options of the samme kind wish diferent expty dates. They wl be discussed n Subsection 1112 Colles: buying one option and seling an option ofthe other kind Ina cola, youll cal with ste K; and buy apt with ste;

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