Exam MFE

Raise Your Odds with Adapt

PUT-CALL PPUT-CALL ARITY (PCP) PARITY (PCP) Put Utility Values and State Prices
Prepaid Forward & Forward L < p < (q ) f : Utility value per dollar in the up state
",$ = ",$ '
*($,") p L < p L G : Utility value per dollar in the down state
Dividend Structure '
",$ () European: p L < p L f = f = ,*x
No "
' Ou ,' Ot ' O ,'(Ou )
< v G = 1 G = 1 ,*x
Discrete " PV(Divs)
Ou ,Ot Ov ,Ou
,*x = f + G
= f f 5x + G G 5x
Continuous " ,5($,")
= f f + G G

BINOMIAL MODEL BINOMIAL MODEL f
Dividend Structure ",$ () =
Replicating Portfolio f + G
No " *($,")
An option can be replicated by buying shares , , s , 'f"
Discrete " *($,") AV(Divs) 'f" s
of the underlying stock and lending at the
Continuous " (*,5)($,") risk-free rate.
PCP for Stock f G G f
= ",$ '
,*($,") = ,5x = ,*x
LOGNORMAL LOGNORMALMODEL MODEL
PCP for Exchange Option = + Lognormal Model for Stock Prices
, , ~ , p = ~ , p
receive , give up give up , receive Call Put = c}C.
u
' '
(, ) (, ) = ",$ ",$ + u
= p 1
, = , + $
PCP for Currency Exchange Risk-neutral Probability Pricing For > , ln ~ , p
"
C C G I *,5 x
= = 0.5 p
C , C , = C ,*J $ ,*K $ p = p
L L
G C , = C I , where C is in / = ,*x f + 1 G $ |" = " ({,5)($,")
MN O
C *,5 x = f + 1 G $ |" = $ |" p 1
u
PCP for Bonds
= " ",$ ,*($,") Realistic Probability Pricing u
$ = " {,5,C.~ $," }~ $," , ~(0,1)
" = Bond price at time {,5 x u
= Median = " {,5,C.~ $,"

= ,|x
f + 1 G Covariance
$
C {,5 x = f + 1 G " , $ = " C
COMPARING COMPARING
OPTIONS OPTIONS {x *x "
Bounds for Option Prices |x = + Probability

Call and Put Standard Binomial Tree (Forward Tree) Pr $ < = p Pr $ > = +p
bcd* ef* max 0, ' ,*$
= *,5 x}~ x = *,5 x,~ x ln " + ( 0.5 p )( )
bcd* ef* max 0, ,*$ ' p =
*,5 x 1
European vs. American Call = =
1 + ~ x Prediction Interval (Confidence Interval)
' ef* max 0, ' ,*$
bcd* max (0, ) Cox-Ross-Rubinstein Tree The (1 ) prediction interval is given by $ and
European vs. American Put = ~ x = ,~ x $ such that Pr $ < $ < $ = 1 .
Lognormal Tree (Jarrow-Rudd Tree)
u
,*$ ef* max 0, ,*$ ' $ = " {,5,C.~ $," }~ $,"
u u
bcd* max (0, ) = *,5,C.~ x}~ x = *,5,C.~ x,~ x
$ = " {,5,C.~ u $," }~ $,"

Early Exercise of American Option No-Arbitrage Condition
Pr < = = ,L
American Call Arbitrage is possible if the following inequality is 2 2

Nondividend-paying stock not satisfied: = = ,L
< *,5 x < 2
o Early exercise is never optimal.
Conditional and Partial Expectation
o bcd* = ef* Option on Currencies $ $ <
Dividend-paying stock C C G I $ $ < =
o Early exercise is not optimal if Pr $ <
= *K ,*J x}~ x = *K ,*J x,~ x " {,5 $,"
L
Dividends < =
*K ,*J x
Interest on the strike + Implicit Put = p
American Put $ $ >
Early exercise is not optimal if Option on Futures Contracts $ $ > =
Pr $ >
Interest on the strike < ",$ = " (*,5)($ ,") {,5 $,"
" +L
Dividends + Implicit Call = Expiration date of the option =
= Expiration date of the futures contract +p
Different Strike Prices

For L < p < q : ln " + + 0.5 p
" ",$ L =
Call
1 f G
L > p > q = =
p = L
L p < p L
European: L p < p L = ,*x
f + 1 G Expected Option Payoffs
s Ot ,s Ou s O ,s Ov Call Payoff = " {,5 $," L p
> u {,5 $,"
Ou ,Ot Ov ,Ou Put Payoff = p " L

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 BLACK-SCHOLES
BLACK-SCHOLES PRICING MPRICING
ODEL MODEL Rho Barrier Option
Generalized B-S Formula =

=

Three types:
, *
= ' L ' p Knock-in
= ' p ' L s 0 ' 0 Goes into existence if barrier is reached.
' 1 Psi Knock-out
ln ' + p =

=
2 Goes out of existence if barrier is reached.
L = 5
s 0 ' 0 Rebate
Pays fixed amount if barrier is reached.
' 1
ln ' p Greek '*"I = Greek Down vs. Up:
2
p = = L L If C < :

Elasticity Up-and-in, up-and-out, up rebate
B-S Formula for Stock
% change in option price If C > :
= " ,5 $," L ,* $," p = =
% change in stock price Down-and-in, down-and-out, down rebate
= ,* $," p " ,5 $," L Knock-in + Knock-out = Ordinary Option
1 " = "
ln " + + p = ( ) Barrier option Ordinary Option
L = 2
s 1 'f" 0 Special relationships:
If barrier strike:
1 '*"I
ln " + p '*"I = = up-and-in call = ordinary call
p = 2 '*"I
L If barrier strike:

'*"I = '*"I ( ) down-and-in put = ordinary put
= L
Compound Option
B-S Formula for Currency
The value of the underlying option at time L
C C G I
DELTA HEDGING DELTA
HEDGING = "t , , L
= C ,*J $," L ,*K $," p
Overnight Profit The value of the compound call at time L
= ,*K $," p C ,*J $," L
1 3 components in overnight profit: = max 0, "t , , L
ln C + G I + p Gain on stocks The value of the compound put at time L
L = 2
Gain on options = max 0, "t , , L
1 Interest on borrowed/lent money Put-call parity for compound option:
ln C + G I p CallonCall PutonCall = ef* ,*"t
p = 2 Breakeven
The price movement with no gain or loss to delta- CallonPut PutonPut = ef* ,*"t
= L hedger is: Gap Option
L : Strike Price
B-S Formula for Futures
Delta-Gamma-Theta Approximation p : Trigger Price
",$ = " (*,5)($ ,")
1 L determines the amount of the payoff.
= Expiration date of the option "}x = " + " + " p + "
2 p determines whether the option will have a
= Expiration date of the futures contract
Boyle-Emanuel Formula payoff.
0, $ p
C C,$ Boyle-Emanuel periodic variance of return when Payoff =
rehedging every in period : $ L , $ > p
= C,$ ,*$ L ,*$ p L $ , $ p
1 Payoff =
= ,*$ p C,$ ,*$ L x, = p p p 0, $ > p
C,$ 2 ,5$ ,*$
1 Boyle-Emanuel annual variance of return when GapCall = C L L p
ln + p
2 rehedging every in period : GapPut = L ,*$ p C ,5$ L
L =
1 where L and p are based on p
C,$ x, = p p p GapCall GapPut = C ,5$ L ,*$
1 2
ln p
2 Greeks for Binomial Trees Exchange Option
p = = L
f G (, ) = ' L ' p
, 0 = ,5x (, ) = ' p ' L
Greeks
Delta , (, ) ' 1
, 0 , = ln ' + p
2
= = ( ) L =

, 0
s = ,5$ L
1 p = L
' = ,5$ L , 2 , 0 , 0 , 0 p
= 2
0 s 1 2 = bp + p 2b
1 ' 0
' = ,5$ All-or-nothing Option
Delta increases as the stock price increases. Option Payoff Time-t Price
Gamma EXOTIC OPTIONS EXOTIC OPTIONS Asset 0, $ <
u " ,5 $," L
= = = Asian Option Call $ , $ >
u
arithmetic average Asset $ , $ <
s 0 = " ,5 $," L
geometric average Put 0, $ >
' 0 L
s = ' Cash 0, $ <

"L " ,* $," p
Theta = = " Call $1, $ >
$1, $ <
"L Cash ,* $," p
= Change in the option price Put 0, $ >
as time advances Average Price Average Strike Maxima and Minima
max , = max 0, +
= Payoff max 0, max 0,
max , = max , 0 +
Payoff max 0, max 0,
is usually negative. max , = max , > 0
Vega The value of an Asian option is less than or max , = min , < 0
=

= equal to the value of an otherwise equivalent max , + min , = +
~ ordinary option.
s 0 min , = max , + +
As increases:
' 0 Value of average price option decreases
s = ' Value of average strike option increases

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Forward Start Option BROWNIAN MBROWNIAN OTION MOTION Proportional Portfolio
For a call option expiring at time whose strike is Basics of Brownian Motion percentage invested in Asset
set on future date to be " : : Pure/Standard Brownian Motion 1 percentage invested in Asset
" , " , Characteristics: value of the portfolio at time
= " ,5 $," L " ,* $," p 1. 0 = 0
+
= " ,5 $," L ,* $," p 2. + ~ 0,
0 ~(0, )
ln " + + 0.5 p = + b + 1 +
" 3. + () is independent of
L =
( ) If Asset is a risk-fee asset, then:
1 4. () is continuous
ln + ( + 0.5 p )( )
= () is a martingale if + b =

+ = 0

p = L + = () +

The time-0 value of the forward start option is: Properties:
'
C = C," ,5 $," L ,* $," p 1. Quadratic variation = = + 1 +
2. Cubic or higher order variation = 0
Chooser Option
For an option that allows the owner to choose at 3. Total variation = The Black-Scholes Equation
time whether the option will become a European Arithmetic Brownian Motion + 0.5 p p + " =
call or put with strike expiring at time : = + + 0.5 p p + =
" = max " , , , " , , 0 = + () where
0 ~ , p : dividend yield on stock
= ,5 $,"
max 0, , *,5 $,"
" : dividend yield on derivative
Ornstein-Uhlenbeck Process
+ " , , S^a
= + u
C = ,5 $,"
C , , *,5 $,"
, + C , , Geometric Brownian Motion = {,5 }C. ,L ~ $,"


= + ",$
=
= + u
= *,5 }C. ,L ~ $,"
MONTE CMONTE CARLO VALUATION
ARLO VALUATION
1 = 0.5 1 p
Simulating Standard Normal Variables ln = p + ()
Lp 2 = +
L u
= 6 = ,L = 0 ,p "}(") = + 0.5 1 p +

L 1
ln ~ = p , p = p
Simulating Lognormal Stock Prices 0 2
Not interested in the intermediate prices: The followings are equivalent:
u
$ = " {,5,C.~ $," }~ $," The Black-Scholes framework applies. INTEREST RINTEREST
ATE MODELS RATE MODELS
Interested in the intermediate prices: = + General Itos Process for and , ,
u
"}x = " {,5,C.~ x}~ xt
G "
= ( ) + = +
{,5,C.~ u x}~ xu
" , ,
"}px = "}x ln
L
= p + = , , , ,
, ,
. p
"}~ "
t
{,5 , ~ u where
. = 0 u
1 1
. ln
" L
~ = p , p = p , , = * + p ** + "
u C p 2
$,x = $,px {,5,C.~ x}~ xt *
{,5,C.~ u x}~ x Itos Lemma , , =
$ = $,x 1
Risk-neutral vs. True = + p + "
2 Sharpe Ratio
Use the risk-neutral distribution only when , ,
Multiplication Rules
discounting is needed. , =
= 0 = 0 , ,
Use the true distribution when discounting is = 0 =
not needed. Partial PDE for Bond
Sharpe Ratio 1
Control Variate Method = p ** + + , * + "
= + = 2
Risk-neutral Process
where Two Itos processes depending on the same ()
= Control variate estimate for Option = + , + ()
will have equal Sharpe ratios. , ,
= Monte Carlo estimate for Option = , , ()
= Exact/True price of Option Risk-free Portfolio , ,
= Monte Carlo estimate for Option For a portfolio consisting of Asset 1 and Asset 2: = ,
Return on Asset 1 = L + L L "

Return on Asset 2 = p + p p = ,
= + p 2 , C
Total return on the portfolio
= L L + L L + p p + p p Delta-Gamma-Theta Approximation
is minimized when: 1
, The coefficient of = L L L + p p p + , (, ) = + p +
L
= = Risk-free The coefficient of = 0 2
L
p
= + ()
p p p L L L
L = p = p
When is set to minimize : L L p p = = p =

= 1 , p Risk-neutral Pricing

Antithetic Variate Method = + ()
For every , also simulate using 1 .

For every , also simulate using . = + ()

Stratified Sampling
= + = +
Break the sampling space into equal size spaces.
True Measure Risk-neutral Measure
Then, scale the uniform numbers into the equal
size spaces. ~ 0, ~ 0,

~ , ~ ,

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Rendlemen-Bartter Model Cox-Ingersoll-Ross Model Black-Derman-Toy
= + = + 1. Effective interest rates
1 , , = , , ",$ * 2. = 0.5
ln ~ = p , p = p 3. The ratio between two consecutive nodes is
0 2 , = Don" t bother
L u
= 0 ,p~ "}~ " , = Don" t bother p~$ x
Characteristics: , , = , " : short-term volatility
1 1, , f
No mean-reverting , = Yield volatility $ = ln
cannot go negative 2 1, , G
Volatility varies with Useful facts: Forward Price
+ , + = , " , + = ",$ , +
Vasicek Model + , + = ,
= + " , +
=
, , = , , ",$ * " ,
(, )
, = Don" t bother Blacks Formula
Characteristics:
1 ,($,") = 0, L p
, = $,"| = Mean-reverting
= 0, p L
cannot go negative
, , = ,
Volatility varies with ln + 0.5 p
Yield on infinite bond: L =
1 p Duration-hedging
= + To duration-hedge a p -year bond with L -year p = L
2 p
Useful facts: bond: C (0, + )
p , p = C,$ , + =
+ , + = , = C (0, )
+ , + = , L , L
, is a constant. Delta-hedging ln C,$ , +
= 0 <
Characteristics: To delta-hedge a p -year bond with L -year bond:
Mean-reverting ' ",$u
= Caplet
can go negative ' ",$t At time , the value of + 1 -year caplet
Volatility does not vary with max 0, $ '
= Notional
1 + $
A caplet is equivalent to 1 + ' puts with strike
L
price .
L}O )

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