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Introduction
The material in this quick study guide has been done to the best
of my knowledge. Some topics are only covered briefly (Delta-Hedging
and Caps/Floors) while other topics have been omitted (Equity Linked
Annuities and Compound Options w/One Discrete Dividend). All exam
tips are marked in red! This the 1st Edition of my MFE study guide, and
it may be updated in the future with better content. Comments and
questions may be directed via PM to colby2152 on the Actuarial
Outpost.
Put-Call Parity
General Formula: Call(K, T) – Put(K, T) = PV(FO,T – K)
K: strike price
T: exercise time
Put-Call parity usually fails for American-style options.
K1 < K2 < K3
0 ≤ C(K1) – C(K2) ≤ K2 – K1
0 ≤ P(K2) – P(K1) ≤ K2 – K1
*if options are European, then the difference in option premiums must
be less than the present value of the difference in strikes
Option Trends
American options become more valuable as time to expiration
increases, but the value of European options may go up or down.
As the strike price increases for calls or decreases for puts, the options
become less valuable with their price decreasing at a decreasing rate.
If the observed option price differs from its theoretical price, arbitrage
is possible…
u ≥ e(r – δ)h ≥ d
* e( r −δ ) h − d
p =
u−d
u = e( r −δ ) h+σ h
d = e ( r −δ ) h−σ h
Multiple periods: work with future values and compute option prices
retrospectively
*Take step-by-step answers to six digits!
C / P = e− rt E[C / Pbinomial (value)]
American Options
• For an American call, the value of the option at a node is given
by
Call Value = max[S – K *, e–rh(p* Value(Up) + (1 - p*)Value(Down)]
Schroder’s Method
F = S – PV(Div)
S
σF = σS
F
Alternative Trees
Cox Ross-Rubinstein
u = eσ h
d = e −σ h
Lognormal
2) + σ h
u = e (r −δ− 0.5σ
2) −σ h
d = e (r −δ− 0.5σ
McDonald
Assumes S = Sud
Contrary to other forms of the d1 equation that you will see, this is the
only one that you need to know. Currency and Futures options replace
variables of this equation, but it remains the same.
Assumptions/Properties
• returns on stock are normally distributed and independent over
time
• volatility and risk-free rate are both known and constant
• future dividends are known
• there are no transaction costs/taxes
Currency Options
Replace stock price with currency exchange rate and the dividend rate
with foreign risk-free rate – known as Garman-Kohlhagen model
Futures
Replace stock price with forward price and the dividend rate with risk-
free rate.
Option Greeks
Formulas that express the change in the option price when an input to
the formula changes, taking all other inputs as fixed.
Elasticity
• tells us the risk of the option relative to the stock in %terms
S∆
Ω=
C
For a call Ω ≥ 1, while for a put Ω ≤ 0
σ option = σ stock | Ω |
Risk Premium: γ – r = (α – r) Ω
α −r
Sharpe Ratio:
σ
Perpetual Options
σ 2x 2 + 2(r − δ − 0.5σ 2 )x − 2r = 0
Each x value is the present value of 1 when a stock of value S rises or
falls to price H, where the value is (S/H)x
Calls
h1
S
Value: (H − K )
H
h
Maximum H: H * = K 1
h1 − 1
Overnight Profit
OP = C 0 − C1 + ∆(S1 − S0 ) − (e r / 365 − 1)(∆S0 − C 0 )
Delta-Gamma-Theta Approximation
*Delta and Delta-Gamma approximations are contained within the
formula
1
C (St + h ) = C (St ) + ∆ε + Γε2 + h θ
2
Where: ε = St + h − St
Black-Scholes formula
This is different than the Black-Scholes EQUATION that was used for
pricing options. Rather, this equation is a function of the greeks, stock
price, volatility, and risk-free rate.
1 2 2
rC (S ) = σ S Γ + rS ∆ + θ
2
1
Var (Rh ,i ) = (S 2σ2Γh )2
2
Introduction of terms
1) Stochastic process is a random process that is also a function
of time.
2) Brownian motion is a continuous stochastic process
3) Diffusion process is Brownian motion where uncertainty
increases over time
4) Martingale is a stochastic process for which E[Z(t2)] = Z(t1) if t2
> t1
dX(T) = α dt + σ dZ(t)
X(t) = X(a) + α (t − a) + σ t − aξ
Ornstein-Uhlembeck Process
Variation of Arithmetic Brownian motion…
dX (t )
d ln[X (t )] = = α dt + σ dZ (t )
X (t )
2 )(t − a) + σ t − aξ
X(t) = X(a)e(α − 0.5σ
Ito’s Lemma
δC ∂ 2C δC
dC = dS + 0.5 2 (dS )2 + dt
δS ∂S δt
Multiplication Table
dt dZ
dt 0 0
dZ 0 dt
Sharpe Ratio
α −r
= “expected return per unit risk”
σ
α1 − r α 2 − r
THEN =
σ1 σ2
Problems:
• r < 0 is possible
• drift is positive, so r can goto infinity
• volatility is independent of interest rate
Problems:
• drift sends the interest rate to infinity
Problems:
• volatility is independent
P (t ,T , r (t )) = A(t ,T )e −B (t ,T )r (t )
B 2σ 2
r (B (t ,T ) +t −T ) −
A(t ,T ) = e 4a
(1 − e −a (T −t ) )
B (t ,T ) =
a
2
σφ σ
r =b+ −
a 2a
φ: Sharpe Ratio
r : yield to maturity on infinitely lived bond
CIR yield to maturity formulas are too much for an SOA exam which
says a lot.
Model doesn’t have problems like the other models have… “Mean
reversion” prevents interest rate from going to infinity.
Value bonds and options just like we did before, but it MUST BE
DISCOUNTED AT EACH NODE due to varying interest rates.
Types of Options
1) Calls/Puts – American/European
2) Caps/Floors
a. Strike Rate
b. Notional Amount
c. Frequency of Payment
d. Length of contract
Caps & floors control risk and promote parity. Simply, caps are like
calls and floors are like puts. Caplet values are equal to the difference
in the strike rate and given interest rate at a node multiplied by the
notional amount.
Black-Derman-Toy Model
BDT Model is actually not that difficult. It is an binomial evaluation of
the yield curve calibrated to actual results.
δ
(∆ × Sd × e h ) + (B × erh) = Cd
Lognormal
2) + σ h
Black-Scholes Pricing u = e (r −δ− 0.5σ
2) −σ h
ln(Se−δ t / Ke−rt ) + 0.5σ 2t d = e (r −δ− 0.5σ
d1 =
σ t
Schroder’s Method
d2 = d1 − σ t
F = S – PV(Div)
S
C = Se−δ tN(d1) − Ke−rtN(d2 ) σF = σS
F
P = Ke−rtN(−d2 ) − Se−δ tN(−d1)
Path-dependent options
Option Greeks Asian – based on average price
Δ = e-δt N(d1)
Barrier
Elasticity Knock-In + Knock-Out = Standard Option
S∆
Ω= Other Exotic Options
C
Compound
σ option = σ stock | Ω | CallOnOption – PutOnOption =
Risk Premium: γ – r = (α – r) Ω Option − xe−rt1
α −r
Sharpe Ratio:
σ Gap: use trigger in d1, strike in PC parity
Perpetual Options
Delta-Gamma-Theta Approximation σ 2x 2 + 2(r − δ − 0.5σ 2 )x − 2r = 0
1 h1
C (St + h ) = C (St ) + ∆ε + Γε2 + h θ S
2 Value: (H − K )
Where: ε = St + h − St H
h
1 2 2 Maximum H: H * = K 1
rC (S ) = σ S Γ + rS ∆ + θ
2 h1 − 1
1
Var (Rh ,i ) = (S 2σ2Γh )2
2 Vasicek: dr = a(b − r )dt + σ dZ
(α − 0.5σ 2 )(t − a) + σ t − aξ
X(t) = X(a)e
Ito’s Lemma
δC ∂ 2C δC
dC = dS + 0.5 2 (dS )2 + dt
δS ∂S δt
Ornstein-Uhlembeck Process
Variation of Arithmetic Brownian motion…