MSM 3G11/MSM4G11 Mathematical Finance revision 1

1.1

Introduction
Stocks, shares and equities
You should be able to explain what is a share, What is a share?

What is a value of a share?

You should be able to explain what is the actual value of a share and how the value of a share is inuenced by paying dividends to shareholders.

1.2

Supply and Demand

You should be able to explain how the value of shares are determined by the laws of supply and demand.

1.3

Long selling and short selling

What are terms long and short refer to. You should be able to explain the practice of short selling and the motivation behind it.

1.4

Arbitrage

How the laws of supply and demand prevent an instantenous risk free prot? You should be able to explain what is the notion of arbitrage, or equivalently why is impossible to make an instantenous risk free prot. You should be able to use the notion of arbitrage when needed (for example when you deduce the Black-Scholes equation).

1.5

Risk

What is risk? You should be able to explain what is the notion of risk. What are the dierent types of risk? You should be able to explain what is the dierence between specic and non-specic risk and give examples.

1.6

Risk-free investments and arbitrage

You should be able to explain what is a hypothetical risk-free investment, when should you invest in such and investment and when should you keep your money in the bank. You should be able to explain how the market forces (based on the laws of supply and demand) make your hypothetical prot to be equal to the prot obtained by depositing money in the bank.

1.7

Hedging

The term hedging is used to refer to investment strategies that are designed to reduce or minimise the risk to a portfolio of investments. You should be able to explain this in more detials and give examples for hedging strategies.

What are Financial Options?

You should be able to explain what are options in general, what are the European Call and Put options and what is the dierence between a European Call Option and a European Put Option. You should understand and be able to explain what is the value cost of an option. You should understand and know the pay-o functions for all of the European Options considered in this chapter. You should also be able to draw the pay-o diagrams for these options, or any other European option whose pay-o function is given.

Random walk model of asset prices

dS = S (dX + dt) .

It is very important to know the stochastic dierential equation

You should be able to explain the meaning of this equation and what happens when = 0. You should be able to explain what is a random walk and give numerical examples for random walks. You should be able to understand (NOT TO DRAW) the corresponding diagrams for random walks. However, you WILL NOT BE ASKED any MatLAB CODES, or other computer codes for the exam. You should know the following two approximations for the drift and volatility: 1 m= ndt and 1 = (n 1)dt
2 2 n1

i=0

Si+1 Si Si Si+1 Si mdt Si

2

n1

i=0

but you will NOT be asked to derive them. NOTHING will be asked FROM the section 3.1 The size of random uctuations. You will be asked to understand, be able to deduce and to use the Black-Scholes equation: 1 2 2 2V V V S + rV + rS = 0. 2 2 S t S For example you have to use Black-Scholes equation for deducing the boundary conditions for the European vanilla put. Another example where you have to use Black-Scholes equation is the Put-call parity for European options. The full deduction of Black-Scholes equation cannot be asked (because its length), but parts of it can be asked. However, you will not be asked to justify why (dX)2 can be replaced by dt. You have to MEMORIZE the Black-Scholes equation. In general you have to MEMORIZE EVERY FORMULA of the lecture notes UNLESS YOU ARE EXPICITLY TOLD in the revision notes that a given formula does NOT have TO be MEMORIZEd. However, in case of some problems some of the formulas might be given to you. You should be able to discuss the Black-Scholes equation and the corresponding Delta Hedging strategy (section 3.4). You are not required to know how to deduce the diusion equation from the BlackScholes equation using transformation of variables (and fuction), but you are required to know these transformations. Note that this deduction was Question 1(*) from Exercise Sheet 4. None of the problems from the exercise sheets denoted by (*) will be asked. The diusion equation has the solution 1 u= 2

u0 (s) exp

1 (x s)2 ds 4

It is important to know this formula. Based on this formula you can deduce the value of several European options. This means that you can be asked to solve the Black-Scholes equation for all the considered European options, or other options whose pay-o function is given. This means here that you have to be able to deduce u0 (s) for these options. The value of an European vanilla call equals SN(d1 ) E exp(r(T t))N(d2 ) (see problem sheet 4, question 3(*)), where 1 N(q) = 2 1 exp s2 ds, 2
q

d1 =

log(S/E) + (r + 2 /2)(T t) T t

and log(S/E) + (r 2 /2)(T t) d2 = . T t You DONT HAVE TO MEMORIZE the latter formulas for the value of an European vanilla call (or similar formulas for an European put). You are NOT REQUIRED TO DEDUCE these formulas neither, but you might be asked to use these formulas.

Solving The Black-Scholes Equation

All formulas and proofs of this chapter can be asked. The chapter include the following topics: Boundary and nal conditions of European vanilla call and put options, Put call parity for European options, Continuous and discrete dividends, Forward contracts and futures Next, some more details: Please note that for deducing the boundary conditions you need to use both the stochastic equation from the random walk model, the Black-Scholes equation and the pay-o functions. You should know the portfolio V = S + P C corresponding to a put-call parity and the value S + P C = Eer(tT ) of the portfolio. In fact this latter equation is called the put-call parity. You are required to understand and deduce this equation. You should be able to compare the put-call parity and the delta hedging. You should know the modied version of the Black-Scholes equations for continuous dividends. You should be able to explain how this equation can be deduced; that is, to show what are the dierences of this deduction from the deduction of the classical Black-Scholes equation. You can be asked to transform the modied version of the Black-Scholes equations for continuous dividends into the classical Black-Scholes equation for a transformed option (Exercise Sheet 4, Question 6). You should be able to explain what are forward contracts and futures and what is the dierence between a forward contract and an option. You should be able to deduce the equation V 1 2V + 2 F 2 2 rV = 0. t 2 F for the value V (F, t) of an option on futures (Exercise Sheet 4, Question 10).

American options

You should be able to explain what is an American option, what is the dierence between European and American Options and derive the models for an American vanilla put and American vanilla call. It is important to know the boundary conditions. It is especially important to MEMORIZE Figure 11, which contains the pay-o of a Vanilla put and the corresponding values of the European and American Vanilla put options at some time t. It is important to know what is the meaning of the optimal exercise boundary. In particular cases you can be aked to deduce the optimal exercise boundary (see Question 2 of Exercise Sheet 5 for an American perpetual call with a constant dividend yield). You should be able to rewrite the model for an American vanilla put in linear complementarity form using the dierential operator for the diusion equation. You should know the linear complementarity form because it is important for the numerical solutions of American options. It is important to know the eect of continuous dividends on American options and the models for perpetual american options.

Summary of main nancial models

Chapter 6 is a summary of the main nancial models. It is important to MEMORIZE and to be able to deduce all formulas of this chapter. In the cases of dividends and perpetual options the classical models should be adapted using sections 5.5.2 and 5.5.3.

Numerical Methods
the nite dierence approximations, the numerical grid, explicit nite dierence scheme, the implicit nite dierence schem.

You should be able to explain and know:

You should be able to compare the explicit and implicit nite dierence schemes based on stability and eciency. It is important to know the criteria for stability. However, the empirical arguments about stability (section 7.4.1) will not be asked. Computer examples are not asked neither (section 7.7.2). You can be asked to work out numerical problems for European and American vanilla calls and puts. Therefore, it is important to know where the initial conditions are implemented on the grid and how to use the linear complementarity model for the American options.

Exercises
You can be asked to solve exercises similar to the ones presented during the lectures and to the ones of the exercise sheets. Questions of the excersise sheets denoted by a (*) WILL NOT BE ASKED.

Important remarks
Anyting which has been omited from this revision, either accidentally or because of lack of time can be asked during the exam. This includes everything presented during the lectures and all questions from the problem sheets exept the ones denoted by a (*). Questions which are ONLY SIMILAR to the questions from lectures and problem sheets CAN BE ALSO ASKED. ALL FORMULAS have to be MEMORIZED except the ones you were told not to in this revision notes. Please check the electronic les of my presentations to see if anything has been omitted from this revision.