B72 99786 F306? y5onP cane’ Study Manual for Exam MFE/Exam 3F Financial Economics Fifth Edition by ' i f Abraham Weishaus, ' Ph.D., F.S.A., CFA, M.A.A.A. i Note: } NO RETURN IF OPENEDTO OUR READERS: Please check A.S.M.’s web site at www.studymanuals.com for errata and updates. If you have any comments or reports of errata, please e-mail us at mail@studymanuals.com. ‘©Copyright 2008 by Actuarial Study Materials, 276 Roosevelt Way, Westbury, NY 11590. All rights reserved. Reproduction in whole or in part without express written permission from the publisher is strictly prohibited,Contents 1 Put-Call Parity 1.1 Review of derivative instruments Ad. Forwaris . . 11.2 Calland putoptions .. 2... . 1.1.3 Combinations of options 1.2 Putecall parity... . : eee 12.1 Stock put-all parity eee 12.2 Synthetic stocks and Treasuries 1.23. Exchange options . we 1.2.4 Currency options Brercises o.oo eee Solutions... - 2 Comparing Options “American options 2 Barly exercise of American options... . 23. Time to expiry i 24 Dilferent stike prices 24.1 Three inequalities . 242 | oie ae eae Exercises... eet Solutions 3. Binomial Trees—Stack, One Period 3.1 Risk-neutral pricing... 6... ss ee eee 32 Replicating portfolio 33. Volailty Exercises. Solutions. smal ‘Trees—General 4.1 Multi-period binomial trees 42. American options. . 43. Currency options. . 44 Futures 45 Other assets Exercises Solutions 5. Risk-Neutral Pricing SL Pricing with True Probabilities 5 RikeNewral Pricing nd Uiiy Exercises Solutions 6 Binomial Trees: Miscellaneous Topics MERI Sady Maat eon iti Cepia 008 ASM 101 101 104 107 109 47 iww i ConTENTS 61 7 62 Lognormaity and alternative trees. . ng 62.1 Lognormality : ee MB 62.2 Alternative wees... : sng 63° Estimating volatility... sees 120 Exercises. 121 Solutions 123, 7 The Black-Scholes Formula 129 7.1 Black-Scholes Formula for common stock options 130 72. Black-Scholes formula for currency options 132 73. Black-Scholes formula for options on furures 13 Brercises 6-2... 135 Solutions | © 139 8 The Black-Scholes Formula: Greeks Mar 81 Greeks... eee 147 811 148 812 : 15 813 153 Blt 153 B15 157 8.16 : 157 8.17 Greek measures for portfolios. 161 82. Elasticity and elated concepts : 164 82.1 Blasicity . eee vee 164 822 Related concepts . 166 of a portfolio 167 83° What willTbe tested on? . . 168 Enercises 169 Solutions 174 9 The Blac Scholes Formals: Appleton and Veaity 181 9.1 Profit diagrams before maturity... . 181 9.1.1 Call options and bull spreads 181 9.12 Calendar spreads 185 9.2 Volatility ee tee eet 187 9.2.1 Implied volatility «so. 189 92.2. Historical volatility oe siees 190 Exercises. . ee . sess 192 Solutions 2.2... 194 10 Delta Hedging 201 10.1 Overnight profit ona deta hedged portfolio. . eee DL 10.2 The delta-gamma-theta approximation . 2 00s 10.3 Greeks for bino aoe 2 207 104 Rebedging . ee 209 10.5 Hedging multiple Grocks - : 210 10.6 What will Tbe tested on? pare. Exercises a 22 MP Sy Mm Son (Cope 2008 ASMECONTENTS : ¥ Solutions tere an See eee aE alg 11 Asian, Barrier, and Compound Options 27 TLL Asian options. . See 27 | 112 Barer options oe 230 | 11.3 Maxime and minima 233 11.4 Compound options 24 11.4.1 Compound option parity . - - Eee see Ee ete as Eetoag 11.4.2 American options on stocks with one diserete dividend . | Spee eee ; 11.4.3 Bermuda options A a Exercises... See sHeEee eta Solutions: i 12 Gap, Exchange and Other Options 12.1 AiL-or-nothing options 12.2 Gap options 122.1. Definition of gap options 12.2.2 Pricing gap options using Black-Scholes . 1225 Dela odging exp options 123 Exchange options c 124 Other options 12.4.1 Chooser options 1242 Ford ots 13 Brownian Motion 13.1 Brownian motion . | 13.1. Arithmetic Brownian motion ‘| 13.12 Geometric Brownian motion . . . oe 13.13 Jensen’s inequality 132 Differentials : 133 The language of Brownian motion Exercises Solutions 14 [td's Lemma 14.1 16's lemma 142 The Black-Scholes Equation 143 Sharperstio ....... ee. ee 144 Risk-neutral processes... . 145 Valuing a forward onS* 2... | 145.1 The process forS* os... 14.5.2. Derivation of For(S*) Using True Pricing 145.3 Examples ofthe formula for forwards on S? 14.6 Other things know 14.7 What will [be tested on? ww 15 Binomial Tree Models for Interest Rates 39 MB stay Manat ton : Cp 08 ASM15.1 Binomial Trees... . oe 152 The Black-Derman-Toy model...» 152.1 Construction ofa Black-Derman-Toy binor 1522 Pricing caps using a BDT wee Exercises 6.6... ‘ Solutions 16 ‘The Black Formula for Bond Options 17 quran Interest Rate Medes: Vases and CoxIngeil-om 16.1 The Black formula. : 16:2 Pricing caps withthe Black formula. Exercises... « eae Solutions... 17.1 The impossible model 17.2 Equilibrium models. 172.1 Theory . 1722 The Rendleman-Bartter model - 17.23 The Vasicek model... « 17.2.4 The Cox-Ingersoll-Ross model . 17.25 Graphs of Vasicek and Cox-Ingersoll-Ross 17.3 What will The tested on? . . . . 174 Delta hedging . 175 Delta-gamma epproximation Exercises ape eperepeceeeeees Solutions 6.4... 26.2 eee eee Practice Exams 1 9 Practice Exam 1 Practice Exam 2 Practice Exam 3 Practice Exam 4 Practice Exam 5 Practice Exam 6 Practice Exam 7 Practice Exam 8 Practice Exam 9 10 Practice Exam 10 AL Practice Exam 11 ‘MRL Sul Manaal—Sth eon Copyagh 208 ASME 348, 352 359 359 360, 362 363 367 367 368 368 372 373 315 316 318 384 385 385 390 401 403, 409, 41s an a7 & 3a 4) CONTENTS vii Appendices 469 A. Solutions for the Practice Exams an Solutions for Practice Exam I... an Solutions for Practice Exam 2. ea 477 Solutions for Practice Exam 3. : 483, Solutions for Practice Exam 4. 491 Solutions for Practice Exam 5 498 Solutions for Practice Exam 6... ae 505 Solutions for Practice Exam 7 313, Solutions for Practice Exam & 321 Solutions for Practice Exam 9... ss. se. 529 Solutions for Practice Exam 10...) sss. 338 Solutions for Practice Exam 11. . 346 B Solutions to Old Exams 553 B.1 Solutions to SOA Exam MFE, Spring 2007 553 1 B.2 Solutions to CAS Exam 3, Spring 2007 tees 558 B3_ Solutions to CAS Exam 3, Fall 2007 562 i Lessons Corresponding to Questions on Released and Practice Exams 367 Mets Sty aaa onan ‘Copyagh 008 ASNPEF Sealy Maat ton Copy cans ASMPreface ‘Welcome to the MFE/3F exam! ‘The SOA is developing a new Risk Management credential, CERA. Students can qualify for this credential ‘without studying Life Contingencies. To make this possible, this exam was split off from Exam MLC in spring 2007, ‘The CAS decided to join the SOA and jointly sponsor this exam beginning in spring 2008, ‘You will be studying, almost exclusively, option pricing. There will be short discussions of forwards here and there, but almost all of the time you will be pricing calls and puts. You may have encountered basic information on ‘hese when you took Exam FM/2, but you don’t need everything you learned in that course. A brief summary of the information you need is given at the beginning of lesson 1. The rest of the course can then be divided into the elementary part—Chapters 9-14 from the textbook, covered in lessons 1-12; and the edvanced part—Chapters 20— 24 from the textbook, covered in lessons 13-17. The elementary part goes in the following order: |. Principles relating prices of calls and puts, and relating prices of options to each other and bounding them, ‘These principles do not develop exact prices for options, but are general and easy to derive. 2. Pricing options using binomial trees. 3. Pricing options using analytic methods (Black-Scholes). 4 Definition of exotic options, and pricing methods where available. The advanced part covers 1, Theory behind pricing formulas: Brownian motion, It's lemma. 2. Pricing options on bonds; interest ate models ‘The McDonald textbook is an easy read for the clementary part, but becomes more difficult for the advanced part, It tries to avoid higher mathematics. As a result, it wll often skip steps in its derivation of formulas. It also tries to develop differential formulas intuitively, which doesn’t always make them easy to understand, I found the ‘materia in Chapters 20-23 (where It6 processes are discussed) and the beginning of Chapter 24 (where interest rate ‘models are discussed) particularly difficult. These chapters are extensively covered in lessons 13, 14, and 17. ‘Many of the textbock end-of-chapter problems are worth looking at. However, many depend on spreadsheets, provided with the textbook. On an exam, you will neither be given those spreadsheets nor allowed to use Excel, ‘If you use the textbook, refer to the following website for errata forthe first printing: http://www. kellogg northwestern edu/faculty /ncdonald/htm/typos2e_91 -html, or for errata for the second printing: http://www. kelogg northwestern. edu/facul ty /medonald/htm/typos2e_62.htal ‘Table 1 shows the weights given to different topics on this exam in the CAS syllabus and on the SOA sample ‘and the released Spring 2007 exams. The non-syilabus question is on Perpetual Options. ‘The SOA provides 31 sampic exam questions. The distribution of topics in the sample questions is not nec cssarily representative, with 7 questions on Brownian motion and Tt6's lemma, a disproportionate amount. The Spring 2007 MFE exam is a better guide to the distribution of questions you should be expecting, and reports from students taking the three unreleased exams indicated similar distributions on those exams, For the hard topics (Brownian motion and interest rate models), expect about 2 Brownian mation/lt8 process questions and 4 interest rate model questions of which 2 are based on BDT or binomial trees and 2 are based on equilibrium models or the Black formula, [MPEG Study Mena Seon ix Coyeie2008 ASM |x ‘CONTENTS ‘Table 1: Distribution of exam questions | Number of questions: | As ‘SOA | Texibook | Manual | Spring | Fall | Sample | Spring | Topic chapters | lessons | 2007 | 2007 | questions | 2007 Putcall paity and related material | 9 w]a|{s| 3 1 Binomial tees wu | 36 | 4) 4) 4 4 Black-Scholes tee eeveSie| eee aea leeds 4 Delta hedging eas HOE aeaee leat 1 2 Exotic options j 4 far} tf 3s] os 2 16 processes (202 | asta} 1 foo] 7 2 Inerest rte models, ma | 1 2] 0] 6 3 Noton syllabus o|o| o 1 “Total questions, isi at is” ‘Note that the fist 16 questions were never on any exim. However, the other questions, according to student reports, were almost all on unreleased exams. Th particular, #19 end #22 were on the Fall 2007 exam (and possibly ‘other questions in the #17-#20 range), while #21, #23, and #25-~#30 were on the Spring 2008 exam. ‘Thus the i Jiffculty of the questions, if not the distribution, may be indicative of the exam. However the Spring 2008 exam | was considered unusually dificult. “The CAS exams virtually skipped Brownian motion and interest rate models, and the few questions they posed ‘on these topics on their Spring 2007 exam seem to indicate a lack of expertise in their exam committee. The Kz. Then at expiry time T, 1. IfSy s Ko, nelther option pays. 2. Ifa < Sr < Ki, the lower-stike option pays Sr — Kz, which is the net payoff. 3, IfSr > Ki the Jower strike option pays St — Ke and the higher-strike option pays Sr ~ Ki, so the net payoff is the difference, or Ky ~ Ka. ‘To create a bull spread with puts, buy a K;-strike pat and sell a Ky-surike put, K; > Kz. Then at expiry time T, 1. IfSp < Ka, the lower-strike option pays Kz ~ Sr and the higher-strike option pays Ki ~ Sr, for a net payotT of Kp ~ Ky <0. 2. If Ka < Sz < Ki, the lower-strike option is worthless and the higher-strike option pays Ki; ~ Sr, 80 the net payoll is Sp ~ Ky <0. 3. IfSr > K; both options are worthless. Although all the payoffs fora bull spread with puts are non-positive, they increase with increasing stock price, Since the position has negative cost (the option you bought is cheaper than the option you sold), you will gain ifthe stock price is higher. ‘A diagram of the net profit on bull spread is shown in figure 1.32. Bear spreads A bear spread pays off ifthe stock price moves down in price, but subject to a limit. To create a bear spread with puts, buy a K(-strike put and sell a Ky-strike put, Ki > Ko. Then 1, IS 2 Kj, neither option pays. MFR/ Sy Mana—stedion ‘Copy 008 ASME1.1, REVIEW OF DERIVATIVE INSTRUMENTS _ 1 12. IF Ry > Sz > Kp, the higher-strike option pays Ky — Sp. 3. If Sz < Kp, the higher-strike option pays Ki — Sr and the lower-strike option pays Ke - Sp fora net payoff of Ki ~ Ka. ‘To create a bear spread with cals, buy 2 K;-strike call and sell a Ky-stike call, Ky > Kz, Then 1, IFSz 2 K,, the higher-strike option pays Sz ~ Ky and the lower-strike option pays Sy ~ Ka for a net peyof? of Ky ~ Ky <0. 2, If Ky > Sr > Ka, the higher-strike option is worthless and the lower-strike option pays Sy — Kz for a net payoff of Kz ~ Sr <0. 3. If Sp < Kz, both options are worthless, Although ll the payoffs for a bear spread with calls are non-positive, they increase with decreasing stock price, ‘Since the option you bought is cheaper than the option you sold, you will ain ifthe stock price is lower. ‘A diagram of the net profit on a bear spread is shown in figure 1.3 A bull spread from the perspective of the purchaser is a bear spread from the perspective of the writer. Ratio spreads _A ratio spread involves buying n of one option and selling m of another option of the same type ‘where m # 1, Itis possible to make the net initial cost ofthis strategy zero. Box spreads A box spread is a 4-option strategy consisting of buying a bull spread of calls with strikes Ky and K and buying & bear spread of puts with strikes K; and K, K; > K. This means buying and selling the followin; Bull Bear Stike | Spread Spread | Sellcall Buy pur Ko_| Buycall Sell put Assuming European options, whenever you buy a call and sell a put at the same strike price, exercise by one of the parties is certain (unless the stock price is the strike price at maturity, in which case both options are worthless), so itis equivalent to a forward. Thus 2 box spread consists of an agreement to buy the stock for K and sell it for Ky, with definite profit K; ~ Kz. If priced correctiy, there will be no gain or loss regardless ofthe stock price at maturity, Butterfly spreads A butterfly spread is a 3-option strategy, all options of the same type, consisting of buyi ‘bull spreads with strike prices Ks and Kz > Ks and selling m bull spreads with strike prices K and Ky > Kz, with ‘mand n selected so that (for calls) ifthe stock price S7 at expiry is greater than K;, the payoffs net to zero. (IF puts are used, arrange it so that the payoffs are zero if Sr < Ks.) Let's work this out for a buterly spread with calls. For 2 bull spread, the payoff is K ~ Kz when Sr > Ki, So the payoff of the n Ko/Ks bull spreads (since Ky > Kz) is (Ky ~ Ks) and the payoff of the m Ki/Ko bull spreads is mK; ~ Ka). Adding it up (Ka ~ Ka) — (Ki ~ K) = 0 ‘m(K ~ Ks) = (Ky ~ Ko) nh Ki=K mm” y= Ks Inthe simplest ase, m = mand X; is half way between K; and Ky; this isa symmetric butterfly spread. Otherwise the butterfly spread is asymmetric, ‘A diagram of the net profit is in figure 1.4. There is no free lunch, so the 3 options involved must be priced in such 2 way that a butterfly spread loses money if the final stock price is below K, or above Ky. This implies that ‘option prices as a function of strike prices must be convex. This will be discussed on page 35. ‘Min Study Maca eon Ceprign on008 Ash8 1. PUT-CALL PARITY -10| ae 30 40 Figure 1.4: Net profit on butterfly spread. Net profit 20) Net profit, 20] 10] 10 ° ° -10} =10| -20] 3 wT Hw (Net pret on colar (9) Net proton clare sack Figure 1.5: Net profits (price’ accumulated al interest plus final settiement) of a collar and of a collared stock using European options, assuming strike prices of 40 and 60 and current stock price of 50 Calendar spreads Calendar spreads involve buying and selling options of the same kind with different expiry ates, They will be discussed in Subsection 9.1.2. Collars: buying one option and selling an option of the other kind In a collar, you sell a call with strike Ki and buy a put with strike Ke < Ki. Note that if Ky = Kz, exercise of the ‘option is guaranteed at expiry time T, unless Sr = Ki in which case both options are worthless. There is no tisk, ‘and if the options are priced fairly no profit or loss is possible, This will be the basis of put-call parity, which we discuss in the next section. In acollar, since K; > Ka, the collar’s payoff increases below Kz and decreases above Ki, and is flat in between. A Giagram of the net profits in figure 1.54, If you own the stock together with a collar, the result is something like a bull spread, as shown in figure 1.5b. MFEAP Stay Masel eon {Copyrigt 2008 ASM