Mathematical Finance

MA3269
Ryan Heng
November 15, 2014

Chapter 1

Expected Utility
1.1

Definitions

Discrete X

n
X

EU (X + w0 ) =

pi U (xi + w0 )

i=1

Continuous X

Z
EU (X + w0 ) =

f (x)U (x + w0 ) dx
a

1.2

Utility function

A utility function U is strictly increasing. So,

U (x) > U (y),

x > y

and
U (x) = U (y) = x = y .
U is concave (strictly concave) if
U (x + (1 )y) (>) U (x) + (1 )U (y)
and convex (strictly convex) if
U (x + (1 )y) (<) U (x) + (1 )U (y) .

If U is strictly concave (e.g. U (x) =

U 00 < 0, and by Jensens Inequality,

x), the individual is risk averse. Also,

E(U (X)) < U (E(X)) .

1.3

Certainty Equivalent

The certainty equivalent is c = CE(X;U), where

U (c) = E(U (w0 + X)) .
The individual is indifferent between investing in X and having a final wealth
of c.

1.4

Risk Premium

The risk premium is r = RP(X;U), where

U (w0 r) = E(U (w0 + X)) .
Clearly, r = w0 c.

1.5

Investment decision

Invest
Avoid
Indifferent

1.6

EU (X + wo ) > U (w0 )
EU (X + wo ) < U (w0 )
EU (X + wo ) = U (w0 )

c > w0
c < w0
c = w0

r<0
r>0
r=0

Arrow-Pratt Risk Aversion

The ARA of a utility function U is

U 00
= (ln u0 )0 .
U0
A risk averse individual has UARA > 0. If w, UARA > VARA , we say that U is
globally more risk averse than V. This is true if and only if there is an increasing
and strictly concave function g such that
UARA =

U (w) = g(V (w)) .

1.7

Positive affine transformation

V is a positive affine transformation of U if

V = U + ,

> 0, R .

Let V be a positive affine transformation of U. Then U is concave (convex) if

and only if V is concave (convex). Thus they have the same certainty equivalent
and make the same investment decisions. Also, UARA = VARA if and only if U
and V are positive transformations of each other.

1.8

Portfolio selection

An individual will choose to invest a portion of his initial wealth in a risky

investment X that has a random rate of return, r, so as to maximise
E(U (W )) = E(U (w0 (1 + r))),

[0, 1] .

Chapter 2

Markowitzs Portfolio
Theory & CAPM
2.1

Definitions
cov(rp , rq ) = wpT Cwq

cov(ri , rj ) = ij ,

corr(ri , rj ) = ij =
p =

n
X

ij
i j

wi i = T w = wT

i=1

p2 =

n X
n
X

wi wj ij = wT Cw

i=1 j=1

2.2

Useful identities
n
X

(p2 ) = 2
wj ij ,
wi
j=1

(wT Cw) = 2Cw

w

(wT v) = v,
w
cov(rp , rg ) =

2.3

v
1
a

Minimum-variance frontier
2

a( ab )2 + (c ba )
ac b2
  T 1

b
1 C 1 1T C 1
=
c
1T C 1 T C 1

2 =


a
b

wg =

C 1 1
1T C 1 1

1
g = ,
a
3

g =

b
a

2.4

Two Fund Theorem

Let
w1 = wg =

C 1 1
1T C 1 1

and

w2 =

C 1
1T C 1

If b = 1T C 1 > 0, then Fund 2 is efficient. So, any portfolio w1 +(1)w2 ,

where < 1, is efficient.

2.5

One Fund Theorem

If portfolio p lies on the CML, then p = rm + (1 )rf , for some > 0. So,
=
wp =

p rf
= p ,
rm rf

p = m .

(p rf )C 1 ( rf 1)
(p rf )C 1 ( rf 1)
=
c 2brf + arf2
( rf 1)T C 1 ( rf 1)
b
a
C 1 ( rf 1)
=
b rf a

rf < g =
wtan

tan =
2
tan
=

| rf |
=q
c 2brf + arf2

(CML),

c 2rf b + arf2
(b rf a)2
p =

SRp =

2.6

c rf b
b rf a

tan rf
p + rf
tan

(efficient CML)

p rf
p

Capital Asset Pricing Model

We take the market portfolio wm to be wtan . So, the CML can be written as
p
p rf =
(m rf ) .
m
p rf is the risk premium of portfolio p. In general, CAPM holds for any asset
i or porfolio p.
i rf =

im
(m rf ) = i (m rf ),
2
m

p rf =
p =

n
X

rf =

i i m
1 i

pm
(m rf ) = p (m rf )
2
m
T

wi i = w ,

pm

i=1

n
X
= cov(
wi ri , rm )
i=1

Chapter 3

European Option Theory

3.1

Bounds on Option Prices

max{0, S0 KerT } C S0
max{0, KerT S0 } P KerT

Let K2 > K1 . Then,

C(K2 ) C(K1 )
C(K2 ) C(K1 ) erT (K2 K1 )
P (K2 ) P (K1 )
P (K2 ) P (K1 ) erT (K2 K1 )
Let 0 < K1 < K2 . P (K) is convex in K. So,
P (K1 + (1 )K2 ) P (K1 ) + (1 )P (K2 ),

3.2

(0, 1)

Put-Call Parity
C + KerT = P + S0

3.3

Binomial Option Pricing

The replicating portfolio consists of units of shares and $B of risk-free asset.

=

F1u F1d
,
S0 (u d)

B=

u F1d d F1u
ert (u d)

F0 = S0 + B = ert (qF1u + (1 q)F1d )

q=

ert d
ud

(single period t)

F0 = e2rt (q 2 F2uu + 2q(1 q)F2ud + (1 q)2 F2dd )

(path independent)