ACTEX CM2 Formula and Review Sheet

ACTEX Learning
Exam CM2 Formula & Review Sheet

(updated 08/15/2023)
UTILITY THEORY
Utility function U (w) Non-satiation: U ′ > 0 Risk averse: U ′′ < 0
Risk neutral: U ′′ = 0 Risk seeking: U ′′ > 0
Absolute risk aversion Relative risk aversion
Formula A(w) = −U ′′ /U ′ R(w) = −wU ′′ /U ′
Increasing A′ (w) > 0 R′ (w) > 0
Constant A′ (w) = 0 R′ (w) = 0
Decreasing A′ (w) < 0 R′ (w) < 0
Maximum premium P policy holder for random loss X with initial wealth a E[U (a − X)] = U (a − P )
Minimum premium Q insurer for random loss Y with initial wealth a E[U (a + Q − Y )] = U (a)
Absolute dominance
A ≥AD B P (B ≤ A) = 1 FA (x) < FB (x) for some x
First-order stochastic dominance
A ≥F SD B FA (x) ≤ FB (x) always FA (x) < FB (x) for some x.
Second-order stochastic dominance

Z x Z x Z x Z x
A ≥SSD B FA (y) dy ≤ FB (y) dy always FA (y) dy < FB (y) dy for some x
a a a a
A≥AD B =⇒ A ≥F SD B =⇒ A ≥SSD B Converse is not true
RISK MEASURES
Continuous variable Discrete variable

Z ∞ X
Variance (µ − x)2 f (x) dx (µ − xi )2 pi for all i
−∞
Z µ X
i
Semi-Variance (µ − x)2 f (x) dx (µ − xi )2 pi for i: xi < µ

−∞ i
If the distribution is symmetric, Semi-variance = 12 × Variance
Value-at-Risk (VaR) at p VaRp = t where t is the 100p-th percentile, i.e. P (X < t) = p.

For Normal distribution: VaRp = µ + Zp σ
RL P
Shortfall probability at L P (X < L) = −∞ f (x) dx P (X < L) = i pi for i: xi < L
RL
Expected Shortfall at L E [max{0, L − x}] = −∞ (L − x)f (x) dx
P
E [max{0, L − x}] = i (L − xi )pi for i: xi < L
STOCHASTIC RETURNS
Notations For t = 1, 2, . . . , n, it = return over [t − 1, t]

Y
n
Sn = accumulated value of a single investment of 1 at time 0= (1 + ik )
k=1
XY
n−1 n
An = accumulated value of a series of investment of 1 at 0, 1, 2, . . . , n − 1 = (1 + ik )
j=1 k=j
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ACTEX Learning Exam CM2 Formula & Review Sheet 2
IID returns
E[it ] = j Var[it ] = s2 E[Sn ] = (1 + j)n E[Sn2 ] = (1 + 2j + j 2 + s2 )n

(1 + j)n+1
− (1 + j)
E[An ] = s̈ n j = E[A2n ] = (1 + 2j + j 2 + s2 )(1 + 2E[An−1 ] + E[A2n−1 ]) with A1 = S1
j
a+b (b − a)2
Uniform returns X ∼ U (a, b) E[X] = Var[X] =
2 12
1 2 2
Lognormal returns Y ∼ LN (µ, σ 2 ) E[Y ] = exp µ + σ Var(Y ) = exp 2µ + σ 2 × eσ − 1
2
If (1 + it ) ∼ LN (µ, σ 2 ) and independent: Sn ∼ LN (nµ, nσ 2 )
=⇒ ln Sn ∼ N (nµ, nσ 2 )
Y
n
For Vn = P V [Sn ] = (1 + ik )−1 Vn ∼ LN (−µn, nσ 2 )
k=1 =⇒ ln Vn ∼ N (−µn, nσ 2 )
ASSET VALUATIONS
Notations
Cij
Ei = E(Ri ) Vi = σi2 = Var(Ri ) Cij = Cov(Ri , Rj ) ρij = Corr(Ri , Rj ) =
σi σj
X
N X
N X
N X
Portfolio P of N Assets EP = x i Ei VP = x2i Vi + 2 xi xj Cij
i=1 i=1 i=1 j<i
Minimum Variance Portfolio

V2 − C12 σ2
Two Assets with ρ12 ̸= 1: x1 = If ρ12 = ±1: x1 = ∓
V1 + V2 − 2C12 ! σ1 ∓ σ2
X X
- With n-risky assets Lagrangian: F (x, λ) = xi Cij xj − λ xi − 1 gives equations
ij i
X X
2 Cij xj − λ = 0 xi = 1
j i !
X X
Efficient Portfolio Lagrangian given EP : F (x, λ) = V − λ(E − EP ) + µ xi − 1 where V = xi Cij xj
i ij
X
2 Cij xj − λEi − µ = 0
j
X X
Ei x i = E P xi = 1 The solution x is linear in EP
i i
1 V n−1
Portfolio Diversification Given xi = : VP = + C where V = avgi [Vi ], C = avgi̸=j [Cij ]
n n n
E P − rf
CAPM Risk premium = EP − rf Market price of risk = ϕP = ϕM = max ϕP
σP P
EM − r
For P on the capital market line EP − r = · σP
σM
Cov(Ri , RM )
For any security i: Ei − r = βi · (EM − r) where βi =
VM
Single-index model Ri = α i + β i R M + ε i RM and εi are uncorrelated.
εi and εj are independent. E i = α i + β i · EM
Vi = βi2 · VM + Vεi Cij = βi · βj · VM
Multi-factor model Ri = αi + βi1 I1 + · · · + βin In + εi

X
Ei = α i + βij E[Ij ]
j
X X
2
Vi = βij Var[Ij ] +2 βij βik Cov(Ij , Ik ) + Vεi
j j<k
X
Cij = 2 βik βjk Var[Ik ]
i<j

STOCHASTIC CALCULUS
Martingale process Xt Filtration {Ft }t≥0 E[Xs |Ft ] = Xt if t ≤ s E[|Xt |] < ∞
Supermartingale: E[Xs |Ft ] ≤ Xt Submartingale: E[Xs |Ft ] ≥ Xt
Wiener process Wt W0 = 0 Wt − Ws ∼ N (0, t − s) Cov[Ws , Wt ] = min{s, t}
Disjoint increments are independent: i.e. Wt2 − Wt1 and Wt3 − Wt2 are independent
if t1 < t2 < t3
Z T X
n−1
Itô integral σ(Wt , t) dWt = lim σ(Wti , ti )(Wti+1 − Wti )
n→∞
0
"Z i=0 #
T
if σ(·, t) ∈ C 2 and E σ 2 (Wt , dt) dt < ∞
"Z # 0
T
- Itô isometry E σ(Wt , dt) dWt = 0
"0Z # Z
T T
Var σ(Wt , dt) dWt = E σ 2 (Wt , dt) dt
0 0
"Z # Z
T S
- Martingale E σ(Wt , t) dWt FS = σ(Wt , t) dWt if T > S
0 0
Z T Z T Z T
- Linearity (σ(Wt , t) + ν(Wt , t)) dWt = σ(Wt , t) dWt + ν(Wt , t) dWt
0 0 0
"Z # "Z # Z
T T T
- Deterministic integrand E σ(t) dWt = 0 Var σ(t) dWt = σ 2 (t) dt
0 0 0
Z T Z T
Itô Process XT = X0 + µ(Xt , t) dt + σ(Xt , t) dWt dXt = µ(Xt , t) dt + σ(Xt , t) dWt
0 0
ITÔ’S LEMMA & SDE
Itô’s lemma Assuming f (x, t) ∈ Cx2 ∩ Ct1 dXt = µt dt + σt dWt
Using (dWt )2 = dt, dWt dt = 0, dt dWt = 0, (dt)2 = 0:

∂f ∂f 1 ∂2f
df (Xt , t) = dt + dXt + 2
(dXt )2
∂t
∂x 2 ∂x
∂f ∂f 1 ∂2f ∂f
= + µt + σt2 2 dt + σt dWt
∂t ∂x 2 ∂x ∂x
Arithmetic Brownian motion dXt = µ dt + σ dWt XT = X0 + µT + σWT ∼ N (X0 + µT, σ 2 T )
Geometric Brownian motion dSt = µSt dt + σSt dWt

σ2
Apply Itô’s lemma with f (x, t) = e , dXt = µ − dt + σ dWt x
2
2
σ σ2
ST = S0 exp µ − T + σWT ∼ LN ln X0 + µ − 2
T, σ T
2 2
Ornstein-Uhlenbeck process dXt = −κXt dt + σ dWt
Apply Itô’s lemma with f (x, t) = xeκt

Z T
σ2
XT = X0 e−κT + σ e−κ(T −t) dWt ∼ N X0 e−κT , 1 − e−2κT
0 2κ
Mean-reverting process dXt = κ(θ − Xt ) dt + σ dWt
Apply Itô’s lemma with f (x, t) = xeκt

Z T

XT = X0 e−κT + θ 1 − e−κT + σ e−κ(T −t) dWt
0

−κT −κT
σ2
∼ N X0 e +θ 1−e , 1 − e−2κT
2κ
p
Feller (CIR) process dXt = κ(θ − Xt ) dt + σ Xt dWt

INTEREST RATE MODELS
Interest rates R(t, T ) = effective interest rate, r(t, T ) = continuous rate,

P (t, T ) = discount bond price at t with expiry T
1
P (t, T ) = Short rate: rt = r(t, t + δ) ≈ R(t, t + δ)
(1 + R(t, T ))T −t
= exp [−(T − t)r(t, T )]
1
P (0, t) T −t (r(0, T ) − r(0, t))T
Forward rates Discrete: F (0; t, T ) = − 1 Continuous: f (0; t, T ) = r(0, t)+
P (0, T ) " Z # T −t
T
∂
Instantaneous lim f (0; t, T ) = − ln P (0, T ) P (t, T ) = exp − f (s, u) du
t→T − ∂T t
forward rates
Short-rate model drt = µ(t, rt ) dt + σ(t, rt ) dŴt under Martingale measure Q
If P (t, T, rt ) = g(t, rt ): g must satisfy:

∂g ∂g 1 ∂2g 2
g(T, r) = 1 and + µ(t, rt ) + σ (t, rt ) − rt g(t, rt ) = 0
∂t ∂r 2 ∂r2
Vasicek’s model drt = κ(θ − rt ) dt + σdŴt θ : mean level of short rate, κ: speed of reversion
∂g ∂g 1 ∂2g 2
g(t, rt ) = P (t, T ; rt ): g must satisfy g(T, r) = 1 and + κ(θ − rt ) + σ − rt g(t, rt ) = 0
" !# ∂t ∂r 2 ∂r2
Z T
P (t, T ) = E exp rs ds = exp[H(T − t) − G(T − t)rt ] where:
t

1 σ2 σ2 2
G(τ ) = 1 − e−κτ H(τ ) = θ − 2 [G(τ ) − τ ] − G (τ )
κ κ 4κ
√ ∂g ∂g 1 ∂2g 2
CIR model drt = κ(θ − rt ) dt + σ rt dŴt + κ(θ − rt ) + σ rt − rt g(t, rt ) = 0
∂t ∂r 2 ∂r2
√
P (t, T ) = exp [H(T − t) − G(T − t)rt ] where γ = κ2 + 2σ 2 and
!
2 (eγτ − 1) 2κθ 2γ exp 12 (γ + κ)τ
G(τ ) = H(τ ) = 2 ln
(γ + κ) (eγτ − 1) + 2γ σ (γ + κ) (eγτ − 1) + 2γ
Hull-White model drt = κ(t)(θ(t) − rt ) dt + σ dŴt Same as Vasicek except G(T − t), H(T − t) replaced
with:
Z T Z s Z T
1
G(t, T ) = exp − κ(u) du ds H(t, T ) = − κ(s)θ(s)G(s, T ) − σ 2 G2 (s, T ) ds
t t t 2
RISK MODELS
Credit risk Expected Credit Loss (ECL) = Exposure At Default (EAD) × Probability of Default (PD)
×Loss Given Default (LGD)
Recovery rate = 100%−LGDProvision = PV[ECL]
Firm valuation Vt : firm’s value, Dt : debt, Et : equity Vt = Et + D t
Merton’s model If Dt = D ET = max{VT − D, 0} Et = Vt Φ(d1 ) − De−r(T −t) Φ(d2 )
σ E Et ln VDt + (r ± σV2 /2)(T − t)

Implicit equation for σV : σV = d 1 = √
Et + De−r(T −t) Φ(d2 ) σV T − t
√
1 − Φ(d2 ) = Φ(−d2 ) d2 = d1 − σV T − t
Risk-neutral PD= Φ(−d2 ) For real world probabilities, replace µV with r

when calculating d1 and d2
Poisson model, L: Loan’s value λ: Rate of default E[loan’s value] = Le−λT

no recovery if no default (hazard rate)

Model with q(t, T ): PD at t δ = recovery rate P (t, T ) = Loan’s value at t

recovery expiring at T if no default

1 E[loan’s value]
E[loan’s value] = P (t, T )[q(t, T )δ + (1 − q(t, T ))] q(t, T ) = 1−
1−δ P (t, T )
Jarrow-Lando- Q(t, T ) = k × k credit-rating transition matrix with default as the k-th state
Turnbull model Λ = hazard rate matrix
Diagonalizable: Λ = Σ D Σ−1 D = Diag[dj ], Σ = [σij ], Σ−1 = [σ̂ij ]
X
k−1
Q(t, T ) = ΣeD(T −t) Σ−1 qik (t, T ) = σij σ̂jk edj (T −t) − 1
j=1
" " Z ## !
X
k−1 T
−1
If Λ = Λ(t) = ΣDU (t)Σ : qik (t, T )| U (t) = σij σ̂jk E exp dj U (s) ds −1
j=1 t
LIABILITY VALUATIONS
General loss Cij = rj · si · xi+j + eij Cij : incremental claim in AYi -DYj
development model
rj : development factor (df) for DYj
si : exposure parameter for AYi
xi+j : parameter for CYi+j eij : error
1X
n
Development factors Arithmetic avg: fj = fij
n i=1
X
fij × Li,j−1
i Li,j
Weighted avg: fj = X fij = where Li,j is cumulative
Li,j−1 Li,j−1
i
Chain-ladder (CL) Cij = rj · si + ei Estimated ultimate claimsi = Lij × fult

where fult = fj × fj+1 × · · ·
Inflation adjusted CL Cij = rj · si · xi+j + eij To adjust for inflation, first convert cumulative figures
to incremental figures
Average cost per claim (1) Calculate past ACpC (2) Develop average ACpC (3) Develop claim count
(ACpC)
Estimated ultimate claimsi = Ultimate ACpCi × Ultimate claim counti
Bornhuetter-Ferguson Estimated ultimate loss = Earned premium × Loss Ratio;

method
] Estimated reserve = Estimated ultimate loss ×(1 − 1/fult )
RUIN THEORY
X
N (t)
Aggregate claim S(t) = Xi N (t): number of claims, Xi : amount for i-th claim, S(t) : aggregate claim
i=1
Surplus process U (t) = U + ct − S(t) U : initial surplus c: premium income rate
Ruin probability Ψ(U ) = P [U (t) < 0 for some t : 0 < t < ∞], Ψ(U, t) = P [U (τ ) < 0 for some t : 0 < τ ≤ t]
Ψ(U ), Ψ(U, τ ) are decreasing in U , increasing in τ , Ψ(U, τ ) < Ψ(U ) lim Ψ(U, t) = Ψ(U )
t→∞
k
(λt)
Poisson process N (t): Poisson process with rate λ P [N (t) = k] = exp[−λt]
k!
Inter-event time: P (Tk > t) = exp[−λt]

Lundberg’s Ψ(U ) ≤ exp[−RU ] R: adjustment coefficient For large U , Ψ(U ) ≈ exp[−RU ]

inequality
Compound Poisson E[S(t)] = λtE[Xi ] Var[S(t)] = λtE[Xi2 ] MS (r) = exp[λt(MX (r) − 1)]
model
To make E[U (t)] > U : c = (1 + θ)λE[Xi ] θ: premium loading factor (θ > 0)
λ
R is the unique positive root of: λ(MX (r) − 1) − cr = 0 If Xi ∼ Exp(α): R = α −
c
2(c − λE[Xi ]) 1 c
Bounds for adjustment coefficient: R < If Xi ≤ M : R > ln
λE[Xi2 ] M λE[Xi ]
θ 1 erb − era
Moment generating Exp(θ) : MX (r) = Γ(k, θ) : MX (r) = Unif[a, b] : M X (r) =
θ−r (1 − rθ)k r(b − a)
functions
General aggregate c > E[Si ] Si : aggregate claim in year i γ > 0: lim− E[exp[r(Si − c)]] = ∞
r→γ
model
R is unique positive value satisfying: E[exp[R(Si − c)]] = 1
Ruin probability Ψ(U, τ ) decreases For compound Poisson Ψ(U, τ ) increases for larger λ
dependence for larger θ models:

1 θU
If Xi ∼ Exp(1) Ψ(U ) = exp −
1+θ 1+θ
Proportional c = [(1 + θ) − (1 + ξ)(1 − α)]λE[Xi ]
reinsurance
ξ: reinsurer premium loading factor α: retention level
Reinsurer constraint: Primary insurer constraint:

ξ−θ θ
α> α>1− ξ>θ
1+ξ ξ
If θ = ξ, then α > 0. i.e. any retention level is possible.
Excess of loss c = (1 + ξ)λE[Yi ] − (1 + θ)λE[Zi ]

reinsurance
Reinsurer loss: Zi = max{0, Xi − M }
Primary insurer loss: Yi = min{X, M }

Z M !
R satisfies: λ + cR = λ e fX (x) dx + e (1 − FX (M ))
Rx RM
0
M = retention level
OPTION THEORY
Notations St / Bt : share/bond price K: strike T : expiry ϕt / ψt : number of shares/bond
ct / pt : European call/put price
Ct / Pt : American call/put price r: risk-free rate
σ: share price volatility δ: continuous dividend yield I: fixed dividend at t = 0
Self-financing (ϕt , ψt ) satisfying: V (t) = ϕt St + ψt Bt dV (t) = ϕt dSt + ψdBt

strategy
Replicating Self-financing (ϕt , ψt ) satisfying: where XT is the derivative payoff

strategy ϕ T ST + ψ T B T = X T
Option payoff European call: European put:

max(ST − K, 0) max(K − ST , 0)
Option bounds Option Type Upper bound Lower bound
European call c t ≤ St ct ≥ St − K exp[−r(T − t)]

American call C t ≤ St Ct ≥ St − K exp[−r(T − t)]
European put pt ≤ K exp[−r(T − t)] pt ≥ K exp[−r(T − t)] − St
American put Pt ≤ K Pt ≥ K − S t
Parameter-price Increased parameter Call price Put price

relationship
Strike (K) Decrease Increase
Time to expiry (T − t) Increase Increase
Volatility (σ) Increase Increase
Risk-free rate (r) Increase Decrease
Dividend (δ) Decrease Increase
Share price (St ) Increase Decrease
Forward price zero dividend: S0 erT fixed dividend: (S0 − I)erT continuous dividend:
S0 exp[(r − δ)T ]
One-period replicating portfolio

V u − Vd uVd − dVu
∆ = ϕ0 = B = ψ0 = V0 = ∆S0 + B
S0 eδh (u − d) erh (u − d)
Risk-neutral Q(price increase) V0 = e−rh EQ [V (n)] Q: Risk-neutral Measure
probability
e(r−δ)h − d
=q=
u−d
h √ i h √ i
Calibrating u = exp σ h + δ dt d = exp −σ h + δ dt h→0:

binomial model St σ2
ln ∼N r− t, σ 2 t
S0 2
q 1−q
State-price A1 = e−r if S1 = S0 u A1 = e−r if S1 = S0 d V0 = EP [A1 V1 ]
p 1−p
deflator (δ = 0) N n n−Nn
q 1−q
An = e−rn
p 1−p
Nn : number of up’s til time n V0 = EP [An Vn ]
BLACK-SCHOLES MODEL
Equivalent measure P ∼ Q are equivalent ⇐⇒ P (E) > 0 whenever Q(E) > 0 for any event E.
Z t
Cameron-Martin-Girsanov There exists an equivalent measure Q s.t. Wt + γs ds is a Wiener process,
0
where γs is a previsible process.
µ−r
Martingale discounted price To make e−rt St martingle, apply CMG with γt = ,
σ
σ2
where St = S0 exp µ − t + σWt
2
Martingale representation Xt , Yt : martingale. Then, dYt = ϕt dXt for some ϕt
⇐⇒ Xt is not martingale under any other equivalent measure.
Black-Scholes formula (δ = 0) ct = St N (d1 ) − Ke−r(T −t) N (d2 ) pt = Ke−r(T −t) N (−d2 ) − St N (−d1 )
ln(St /K) + (r + 12 σ 2 )(T − t) √

d1 = √ d2 = d1 − σ T − t
σ T −t
∂f ∂f σ 2 St2 ∂ 2 f
Black-Scholes Equation (δ = 0) + rSt + = rf (t, St ) f (T, s) = (s − K)+ for call, (K − s)+ for put
∂t ∂s 2 ∂s2

BSE derivation (δ = 0) V (t, St ): portfolio value with f = f (t, St ): option value

∂f ∂f
1 derivative and shares =⇒ dVt = −df + dSt
∂s ∂s
Applying Itô’s lemma: Arbitrage-free implies:

∂f 1 ∂2f 2 2 dVt = rVt dt
dVt = − − σ St dt
∂s 2 ∂s2
Martingale approach (δ = 0) Ft : filtration, Find equivalent measure Q

X: contingent derivative payment s.t. Dt = e−rt St is martingale
f (t, St ) = exp[−r(T − t)]EQ [X|Ft ] Then, Et = e−rt f (t, St ) is martingale
For some ϕt : dEt = ϕt dDt Let ψt = Et − ϕt Dt

(martingale representation)
(ϕt , ψt ) is self-financing. Derivative value: f (t, St ) = ϕt St + ψt Bt
Martingale to BSE (δ = 0) dEt = e−rt (−rf (t, St ) dt + df )

∂f ∂f ∂f σ 2 St2 ∂ 2 f
= dDt + e−rt −rf (t, St ) + + rSt + dt
∂s ∂t ∂s 2 ∂s2
∂f
Martingale representation: dEt = ϕt dDt =⇒ ϕt =
∂s
∂f ∂f σ 2 St2 ∂ 2 f
Martingale =⇒ −rf (t, St ) + + rSt + =0
∂t ∂s 2 ∂s2
State-price deflator approach (δ = 0)
P ∼ Q: By CMG, dZet = dZt + γt dt

P
dSt = µSt dt + σSt dZt
µ−r
= rSt dt + σSt dZet
Q
with γt =
σ
1
ηt = exp −γZt − γ 2 t State-price deflator: At = e−rt ηt
2

−r(T −t) −r(T −t) ηT EP [AT X|Ft ]
f (t, St ) = e EQ [X|Ft ] = e EP X Ft =
ηt At
BSE derivation (δ > 0) Set : value of investment starting with S0 dSet = (µ + δ)Set dt + σ dZt

σ2
Set = Se0 exp µ + δ − t + σZt Change in derivation:
2
∂f
dVt = −df + (dSt + δSt dt)
∂s
∂f ∂f σ 2 St2 ∂ 2 f
+ (r − δ)St + = rf (t, St )
∂t ∂s 2 ∂s2
Black-Scholes formula (δ > 0) ct = St e−δ(T −t) N (d1 ) − Ke−r(T −t) N (d2 )
pt = Ke−r(T −t) N (−d2 ) − St e−δ(T −t) N (−d1 )
ln(St /K) + (r − δ + 12 σ 2 )(T − t) √

d1 = √ d2 = d1 − σ T − t
σ T −t
∂f ∂2f ∂f
Option Greeks ∆= ,Γ= ,Θ= , BSE (δ = 0):
∂s ∂s2 ∂t
1
ν=
∂f
,ρ=
∂f
,λ=
∂f Θ + rs∆ + σ 2 s2 Γ = rf
∂σ ∂r ∂δ 2
∆call = e−δ(T −t) N (d1 ) ∆put = −e−δ(T −t) N (−d1 )


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Exam CM2 Formula & Review Sheet

Utility function U (w) Non-satiation: U ′ > 0 Risk averse: U ′′ < 0

Risk neutral: U ′′ = 0 Risk seeking: U ′′ > 0

Absolute risk aversion Relative risk aversion

Formula A(w) = −U ′′ /U ′ R(w) = −wU ′′ /U ′

Increasing A′ (w) > 0 R′ (w) > 0

Constant A′ (w) = 0 R′ (w) = 0

Decreasing A′ (w) < 0 R′ (w) < 0

A ≥AD B P (B ≤ A) = 1 FA (x) < FB (x) for some x

First-order stochastic dominance

A ≥F SD B FA (x) ≤ FB (x) always FA (x) < FB (x) for some x.

Second-order stochastic dominance

A≥AD B =⇒ A ≥F SD B =⇒ A ≥SSD B Converse is not true

Continuous variable Discrete variable

Semi-Variance (µ − x)2 f (x) dx (µ − xi )2 pi for i: xi < µ

If the distribution is symmetric, Semi-variance = 12 × Variance

Value-at-Risk (VaR) at p VaRp = t where t is the 100p-th percentile, i.e. P (X < t) = p.

Notations For t = 1, 2, . . . , n, it = return over [t − 1, t]

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E[it ] = j Var[it ] = s2 E[Sn ] = (1 + j)n E[Sn2 ] = (1 + 2j + j 2 + s2 )n

Minimum Variance Portfolio

εi and εj are independent. E i = α i + β i · EM

Vi = βi2 · VM + Vεi Cij = βi · βj · VM

Multi-factor model Ri = αi + βi1 I1 + · · · + βin In + εi

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Martingale process Xt Filtration {Ft }t≥0 E[Xs |Ft ] = Xt if t ≤ s E[|Xt |] < ∞

Supermartingale: E[Xs |Ft ] ≤ Xt Submartingale: E[Xs |Ft ] ≥ Xt

Wiener process Wt W0 = 0 Wt − Ws ∼ N (0, t − s) Cov[Ws , Wt ] = min{s, t}

ITÔ’S LEMMA & SDE

Itô’s lemma Assuming f (x, t) ∈ Cx2 ∩ Ct1 dXt = µt dt + σt dWt

Using (dWt )2 = dt, dWt dt = 0, dt dWt = 0, (dt)2 = 0:

Geometric Brownian motion dSt = µSt dt + σSt dWt

Apply Itô’s lemma with f (x, t) = xeκt

Apply Itô’s lemma with f (x, t) = xeκt

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INTEREST RATE MODELS

Interest rates R(t, T ) = effective interest rate, r(t, T ) = continuous rate,

Short-rate model drt = µ(t, rt ) dt + σ(t, rt ) dŴt under Martingale measure Q

If P (t, T, rt ) = g(t, rt ): g must satisfy:

Recovery rate = 100%−LGDProvision = PV[ECL]

Firm valuation Vt : firm’s value, Dt : debt, Et : equity Vt = Et + D t

Merton’s model If Dt = D ET = max{VT − D, 0} Et = Vt Φ(d1 ) − De−r(T −t) Φ(d2 )

σ E Et ln VDt + (r ± σV2 /2)(T − t)

Risk-neutral PD= Φ(−d2 ) For real world probabilities, replace µV with r

Poisson model, L: Loan’s value λ: Rate of default E[loan’s value] = Le−λT

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Model with q(t, T ): PD at t δ = recovery rate P (t, T ) = Loan’s value at t

Diagonalizable: Λ = Σ D Σ−1 D = Diag[dj ], Σ = [σij ], Σ−1 = [σ̂ij ]

si : exposure parameter for AYi

xi+j : parameter for CYi+j eij : error

Chain-ladder (CL) Cij = rj · si + ei Estimated ultimate claimsi = Lij × fult

Bornhuetter-Ferguson Estimated ultimate loss = Earned premium × Loss Ratio;

Surplus process U (t) = U + ct − S(t) U : initial surplus c: premium income rate

Inter-event time: P (Tk > t) = exp[−λt]

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Lundberg’s Ψ(U ) ≤ exp[−RU ] R: adjustment coeﬀicient For large U , Ψ(U ) ≈ exp[−RU ]

Reinsurer constraint: Primary insurer constraint:

Excess of loss c = (1 + ξ)λE[Yi ] − (1 + θ)λE[Zi ]

Primary insurer loss: Yi = min{X, M }

Notations St / Bt : share/bond price K: strike T : expiry ϕt / ψt : number of shares/bond

ct / pt : European call/put price

Ct / Pt : American call/put price r: risk-free rate

σ: share price volatility δ: continuous dividend yield I: fixed dividend at t = 0