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# MFE Notes - Spring 2010 Sitting

## – with Calls: buy CK2 and sell CK1 ; K1 > K2

– with Puts: buy PK2 and sell PK1 ; K1 > K2

## – with Calls: buy CK1 and sell CK2 ; K1 > K2

– with Puts: buy PK1 and sell PK2 ; K1 > K2

## – same K ⇒ Payoff = |ST − S0 |

– bet on volatility
– Strangle - buy PK2 and CK1 ; K1 > K2

• Conversion

## – Synthetically buy a T-bill

– Lend dollars

• Reverse Conversion

## – Synthetically sell a T-bill

– Borrow dollars

1
• Converting between domestic and foreign currency options:

## – A put denominated in the base currency is equivalent to some

number of calls denominated in the foreign currency
 
– KPd x10 , K1 , T = Cd (x0 , K, T )
 
1 1
– Kx0 Pf x0 , K , T = Cd (x0 , K, T )

## – The verb applie to the market-maker, not the retail customer

∗ The market-maker bids the bid price when buying a share of
stock
∗ The market-maker asks the ask price when selling a share of
stock
∗ Bid Price < Ask Price

## Lesson 2 - Comparing Options

• American Options:

(S) − Ke−rT , S0 − K
P

– Calls: S ≥ CA ≥ CE ≥ max 0, F0,T
– Puts: K ≥ PA ≥ PE ≥ max 0, Ke−rT − F0,T
P

(S), K − S0

## • Early exercise of American Options

– Calls:
∗ lose the implicit Put
∗ if non-dividend then CA = CE
∗ not rational if P Vt,T (Div) < K(1 − e−r(T −t) ) + P
· b/c you get stock and Divs. but pay K and lose the im-
plicit Put
– Puts:
∗ lose the implicit Call

2
∗ may be rationa even if no dividends
∗ earn interest on K

## • Different Strike Prices

– Direction:
∗ C1 ≤ C2 and P1 ≤ P2
∂C ∂P
∗ ∂K ≤ 0 and ∂K ≥0
– Slope:
∗ C1 − C2 ≥ K2 − K1 and P1 − P2 ≤ K1 − K2
∂C ∂P
∗ ∂K ≥ −1 and ∂K ≤1
– Convexity:
C1 −C2 C2 −C3 −P2 P2 −P3
∗ K1 −K2
≥ K2 −K3
and KP11 −K 2
≥ K2 −K3
∂2C ∂2P
∗ ∂K 2
≥ 0 and ∂K 2 ≤ 0
· K1 > K2 > K3

• Strike Price Increases Over Time on a Call - suppose that a stock does
not pay dividends and the strike price increases at a rate that is less than
or equal to r:
KT ≤ Kt er(T −t)
The longer the call option, the more valuable it is:
C(S0 , KT , T ) ≥ C(S0 , Kt , t) for T > t
If the inequality above is violated, then arbitrage is available.
That is if:
KT ≤ Kt er(T −t) and C(S0 , KT , T ) < C(S0 , K, T )
then arbitrage can be obtained with the following steps:

## 1. Buy the longer option and sell the shorter one

2. At time t, the shorter option is in the money, sell stock short and
lend Kt at the risk-free rate

## Lesson 3 - Binomial Trees - Stock, One Period

3
• Replicating Portfolio: B stands for bond, not borrowing; amount we
lend
 
−δh Cu −Cd
• ∆=e S(u−d)

uCd −dCu
• B = e−rh

u−d

e(r−δ)h −d
• p∗ = u−d

• C = S∆ + B

## • Multinomial Trees: Set up equations as:

rh
P rice1 ∆1 + · · · + P ricen ∆n + Be = P ayof f1

n+1 times .. .. .. ..
. ··· . . .
P rice ∆ + · · · P rice ∆ + Berh = P ayof f

1 1 n n n

– p∗ = 1√
1+eσ h

Ft,t+h /St −d
– p∗ = u−d
= 1−d
u−d
Cu −Cd
– ∆= F (u−d)
uCd −dCu Cu −Cd
– B = C = e−rh

u−d
+ u−d

## Lesson 5 - Risk-Neutral Pricing

4
• Seαh = puSeδh + (1 − p)dSeδh

e(α−δ)h −d
– ⇒p= u−d

S∆ B
• eγh = S∆+B
eαh + S∆+B
erh

## – γ ∼ discount rate for an option

– γCall > α > r > γP ut

## – ⇒ C = e−γh (pCu + (1 − p)Cd ) = e−rh (p∗ Cu + (1 − p∗ )Cd )

∗ If Cd = 0 ⇒ e−γh p = e−rh p∗

## – Ui ∼ current value of \$1 paid at the end of one year when the

price of the stock is in state i
∗ UH ≤ UL because of decling MU
1
∗ if risk-neutral: UH = UL = 1+r
– Ci ∼ cash flow of the stock at the end of one year in state i
– Qi ∼ the current value of \$1 paid at the end of one year only if
the price of the stock is Ci

• Important Formulas:

– QH = pUH QL = (1 − p)UL
1
– QH + QL = 1+r
– C0 = pUH CH + (1 − p)CL QL = QH CH + QL CL
pCH +(1−p)CL pCH +(1−p)CL pCH +(1−p)CL
– 1+α= C0
= pUH CH +(1−p)UL CL
= QH CH +QL CL
pUH QH
– p∗ = pUH +(1−p)CL
= QH +QL

5
p∗ UL
∗ ⇒ solve for p ⇒ p = p∗ UL +(1−p∗ )UH

## – Compare S(1 − e−δt ) vs. K(1 − e−rt )

∗ depends on Call vs. Put

## – if annual volatility is σ ⇒ monthly is √σ

12
– Cox-Ross-Rubinstein Tree
∗ centered

on 1 √
∗ u=e σ h
d = e−σ h

## – Lognormal / Jarrow-Rudd Tree

1 2
∗ centered on er−δ− 2 σ

• Estimating Volatility
r
√ n
P
x2i

– σ̂ = p n−1 n
− x̄2
 
St
– use ln St−1
for data points

## • If X ∼ N (µ, σ 2 ) then Y = eX ∼ LogN ormal(µ, σ)

• Properties
1 2
– E(Y ) = em+ 2 v
 
2m+v2 v2
– V (Y ) = e e −1

6
2
– mode = em−v
∗ m = µt = α − δ − 21 σ 2 t


∗ v=σ t

• Lognormal Confidence Intervals: Assume that the stock prices are log-
normally
 distributed:

ln SSTt ∼ N (α − δ − 12 σ 2 )(T − t), σ 2 (T − t)
 
T >t
The (1 − p) confidence interval is: 
P r STL < ST < STU = 1 − p
The lower and upper stock prices defining the confidence interval are:
1 2 )(T −t)+|σ L |

T −t
– STL = St e(α−δ− 2 σ Z

1 2 )(T −t)+|σ U |

T −t
– STU = St e(α−δ− 2 σ Z

## ∗ where P r(z < z L ) = p2 and P r(z > z U ) = p2

∗ σ can be given as negative, that’s why abs. value signs are
there

## • Jensen’s Inequality: E(g(X)) ≥ g(E(X))

– E(X 2 ) ≥ (E(X))2

## – P r(ST < K) = N (−dˆ2 ) P r(ST > K) = N (dˆ2 )

P E(X|Y )
– E(X|Y ) = P r(Y )

## – P E[ST |ST > K] = S0 e(α−δ)t N (dˆ1 )

– P E[ST |ST < K] = S0 e(α−δ)t N (−dˆ1 )
– P E[K|ST < K] = KN (−dˆ2 )
– P E[K|ST > K] = KN (dˆ2 )
P E[K−ST |ST <K] KN (−dˆ2 )−S0 e(α−δ)t N (−dˆ1 )
– E[K − ST |ST < K] = P r(ST <K)
= N (−dˆ2 )
P E[ST −K|ST >K] S0 e(α−δ)t N (dˆ1 )−KN (dˆ2 )
– E[ST − K|ST > K] = P r(ST >K)
= N (dˆ2 )

7
• Expected Payoff

## – Call: E[max(0, ST − K)] = S0 e(α−δ)t N (dˆ1 ) − KN (dˆ2 )

– Put: E[max(0, K − ST )] = KN (−dˆ2 ) − S0 e(α−δ)t N (−dˆ1 )

• Expected Value
1 2
– E[ST |S0 ] = S0 e(µ+ 2 σ )t

## Lesson 8 - Fitting Stock Prices to a Lognormal Distribution

 
St
• Estimate using ln St−1
as data points

• Annual Return: α̂ = µ̂ + 12 σ̂ 2

## 1. Sort the data into order statistics, from smallest to largest

2. Convert the order statistics into quantiles by matching them with
the appropriate cumulative probabilities
3. Match each cumulative probability with its corresponding z-value
4. Graph the points with the quantiles on the horizontal axis and
the z-values on the vertical axis
5. Draw a straight line through the 25% and 75% quantiles

## – C = F e−rt N (d1 ) − Ke−rt N (d2 )

– P = Ke−rt N (−d2 ) − F e−rt N (−d1 )
F
ln( K )√+ 21 σ2
– d1 = σ t

– d2 = d1 − σ t

8
• The futures period affects the forward price of the stock but does not
affect the option price in any other way

## Lesson 10 - The Black-Scholes Formula: Greeks

• ∆C − ∆P = e−δt

– ∆C = e−δt N (d1 )
– S-shaped

• ΓC = ΓP

## – Symmetric hump, peak to the left of K (further with higher t)

• V egaC = V egaP

## – Asymmetric hump; peak similar to Γ

• Ct − Pt = −δSe−δt + rKe−rt
1 δSe−δt −rKe−rt
– Θ = − 365 Ct ⇒ ΘC − ΘP = 365
– Upside-down hump; almost always < 0 unless far in the money

• ρC − ρP = .01tKe−rt

## – Assuming ρ expressed in terms of % points

– Increasing curve; positive for C, negative for P

• ΨC − ΨP = −.01tSe−δt

## – Assuming Ψ expressed in terms of % point

– Decreasing curve; negative for C, positive for P

∆/C S∆
– Ω= /S
= C

## – σoption = σstock |Ω|

9
γ−r Ω(α−r) α−r
– γ − r = Ω(α − r) ⇒ σoption
= Ωσstock
= σstock

## • Greek for Portfolio: Σ of the greeks

• Elasticity for Portfolio: Wtd. Average of the Ω’s

## • Purchase a t-day call and hold it for 1 day. Profit =

1. Change in call premium (Ct−1 − Ct )
2. Lost interest (er/365 Ct − Ct )

• Volatility

## – Black-Scholes assumes σ is constant

– Implied Volatility: volatility that reproduces the price of an option
in a pricing model.
∗ Common patterns for implied equity volatilities:
1. Decreases with strike price
2. Flatter curve for longer time until expiration
– Volatility Skew: refers to the fact that the implied volatility is not
constant across strike prices
∗ implied volatility declined as time to expiry increased
∗ implied volatility decreased as K increased
∗ in-the-money call has higher volatility than an out-of-the-
money call
∗ in-the-money put has lower volatility than an out-of-the-money
put
change in C
• ∆= change in S

## Lesson 12 - Delta Hedging

10
• Overnight Profit on a Delta-Hedged Portfolio
r
– Profit = −(C1 − C0 ) + ∆(S1 − S0 ) − (e 365 − 1)(∆S0 − C0 )

## • Break even for Market Maker

– S ± Sσ h

• Delta-gamma-theta approximation

– C1 = C0 + ∆ + 12 Γ2 + θh
∗  = Sh − S0

• Black-Scholes Equation

– rC = S∆(r − δ) + 12 ΓS 2 σ 2 + θh

## • Greeks for Binomial Trees

 
Cu −Cd
– ∆(S, 0) = e−δh S(u−d)
∆(Su,h)−∆(Sd,h)
– Γ(S, h) ≈ Γ(S, 0) = S(u−d)

## – C(Sud, 2h) = C(S, 0) + ∆(S, 0) + 21 Γ(S, 0)2 + 2hθ(S, 0)

C(Sud,2h)−C(S,0)−∆(S,0)− 12 Γ(S,0)2
∗ ⇒ θ(S, 0) = 2h
·  = Sud − S

• Reheding

## – Variance of the return for a single period

∗ V ar[Rh,i ] = 21 (S 2 σ 2 Γh)2
– If we re-hedge every h (measured per year)
∗ Annual Variance of Return = h1 V ar[Rh,i ] = 12 (S 2 σ 2 Γ)2 h

• Misc. Notes

## – Sell Call ⇒ Buy Stock

11
– Sell Put ⇒ Sell Stock

## – max(S, K) = S + max(0, K − S) = K + max(0, S − K)

– max(cS, cK) = c · max(S, K)
– max(S, K) + min(S, K) = S + K

• Compound Options

– CoC − P oC = C − x0 e−rt1
– CoP − P oP = P − x0 e−rt1

## Lesson 14 - Gap, Exchange and Other Options

• All-or-nothing Options

## – S|S > K = S0 e(r−δ)T N (d1 )

– S|S < K = S0 e(r−δ)T N (−d1 )
– c|S > K = ce−rT N (d2 )
– c|S < K = ce−rT N (−d2 )
– Delta for all-or-nothing options
d2
i
∂N (di ) e− 2
∗ ∂S
= √
Sσ 2πT

• Gap Options

12
– Remember that ST > trigger for Calls and ST < trigger for Puts
– Put-Call Parity applies
– If two otherwise identical gap options have different strike prices,
then use linear interpolation to find the price of a third otherwise
identical gap option with a different strike price.

• Exchange Options

## – volatility measures the variance of rate of return (not the dollar

return)i.e. 2 shares have the volatility as 1 share

• Chooser Options

– Derivation

## Vt = max(C(S, K, T − t), P (S, K, T − t)) (1)

= C(S, K, T − t) + max(0, P (S, K, T − t) − C(S, K, T − t) (2)
= C(S, K, T − t) + max(0, Ke−r(T −t) − Se−δ(T −t) ) (3)
= C(S, K, T − t) + e−δ(T −t) · max(0, Ke−(r−δ)(T −t) − S) (4)

## – Purchase a call @ t with K = cSt expiring @ T , then the value of

the forward start option is:
∗ V = Se−δT N (d1 ) − cSe−r(T −t)−δt N (d2 )
· di are computed using T − t as time to expiry

## • Generating LogNormal random numbers

P12
1. Let zj = i=1 ui − 6 where ui ∈ U [0, 1]
−1
2. Let zj = N (uj )

13
• Use r to discount when pricing options

## – Let X ∗ = X̄ + (E(Y ) − Ȳ ), Y ∼ control variate

∗ ⇒ V (X ∗ ) = V (X̄) + V (Ȳ ) − 2Cov(X̄, Ȳ )
∗ Always use sample variance / covariance formula
– Boyle modification:
∗ X ∗ = X̄ + β(E(Y ) − Ȳ )
· ⇒ V (X ∗ ) = V (X̄) + β 2 V (Ȳ ) − 2βCov(X̄, Ȳ )
Cov(X̄,Ȳ )
· Optimal value for β = V (Ȳ )
 

· Variance becomes: V (X ) = V (X̄) 1 − ρ2X̄,Ȳ

## – Stratified Sampling: break sampling space into strata and then

scale uniform #s to be in these strata

## ∗ If you had 4 strata: [0, .25), . . . , [.75, 1) then generate sets of

4 ui on [0, 1), multiply all 4 by .25, put the first in [0, .25),
add .25 to 2nd number, etc.

## – Latin Hypercube Sampling

– Importance Sampling

## Lesson 16 - Brownian Motion

• Random Walk

14
1. X(0) = 0
1

k + 1, with p =
2. For t > 0, if X(t − 1) = k, then X(t) = 2
1
k − 1, with p = 2

3. Memoryless.

## – Sum of the squares of the movement is t

5. X(t) ∼ Bin t, 12


• Brownian Motion

– Move h per h units of time and take limh→0

## ∗ ⇒ Cont. Random Walk and Binomial → Normal

– Properties

1. Z(0) = 0
2. Z(t + s)|Z(t) ∼ N (Z(t), s)
3. Z(t + s1 ) − Z(t) is independent of Z(t) − Z(t − s2 )
4. Z(t) is cont. in t

## – Expected Values Under Pure Brownian Motion

∗ E[Z(t)] = 0
∗ E[Z(t + h)|Z(t)] = Z(t)
∗ E[Z(t + h) − Z(t)] = 0
∗ E[dZ(t)] = 0
∗ E[dZ(t)|Z(t)] = 0
∗ E [(Z(t))2 ] = t

15
∗ E [(dZ(t))2 ] = dt
∗ E[Z(t)Z(s)] = M in(t, s)

## – Variances under Pure Brownian Motion

∗ V [Z(t)] = t
∗ V [Z(t + h)|Z(t)] = h
∗ V [Z(t + h) − Z(t)] = h
∗ V [dZ(t)] = dt
∗ V [dZ(t)|Z(t)] = dt

## – is a diffusion process - cont. process in which the absolute value

of the R.V. tends to get larger

## – is a martingale - process X(t) for which E[X(t + s)|X(t)] = X(t)

∗ ABM and GBM are martingales iff they have zero drift

## • Arithmetic Brownian Motion

– X(t) = αt + σZ(t)

## • Geometric Brownian Motion

 
X(t)
– If ln X(0)
∼ N (µt, σ 2 t) then X(t) − X(0) ∼ LogNormal

1 2 )t
∗ Mean = e(µ+ 2 σ
2 2
∗ Variance = e(2µ+σ )t (eσ t − 1)

## – When dealing with probabilities, you must convert to ABM

16
P
• V ar(ln(S(t))|S(0)) = V ar(ln(F0,T (S))) = V ar(ln(F0,T (S)))

• Forms of BM

dS
– GBM: S
= (α − δ)dt + σdZ

## – ABM: d(ln(S)) = (α − δ − 12 σ 2 )dt + σdZ

• When you add δ to total return (for Sharpe Ratio), only add to S, not
C

## • Portfolio Returns: Suppose that a portfolio P consists of 2 assets, A

and B. If x is the percentage of the portfolio is invested in A and
(1 − x) is the percentage invested in B, then the instantaneous change
in the price of the portfolio is:
dP (t)
P (t)
= x dA(t)
A(t)
+ (1 − x) dB(t)
B(t)
To find the instantaneous return on the portfolio, include the dividends.

## – Instantaneous Return on Portfolio

h i h i
∗ dP (t)
P (t)
+(xδ A +(1−x)δB )dt = x dA(t)
A(t)
+ δ A +(1−x) dB(t)
B(t)
+ δ B

## Lesson 17 - Itô’s Lemma

• dC = CS dS + 12 CSS (dS)2 + Ct dt

## • The Black-Scholes Equation

– rC = S∆(r − δ) + 12 ΓS 2 σ 2 + θh

α−r
– φ= σ

## ∗ α is total return (includes δ)

17
– For 2 Itô processes with the same dZ, the Sharpe Ratios are equal

• Problems which give 2 processes, Prices and ask how much should be
allocated to each process. Such as:

dS1 dS2
1. S1
= α1 dt + σ1 dZ and S2
= α2 dt + σ2 dZ

## (a) Solve S1 · x · α1 + S2 · y · α2 = (S1 · x + S2 · y)r

(b) If you know x and need y, look @ σσ21 , that’s ratio of value of
  Since S1 costs S1 · x then you need
S2 you need to buy/sell.
to buy/sell S1 · x σσ21 = y

 
αi −r αM −r
• CAPM: σi
= ρi,M σM

– φi = ρi,M φM

• Risk-Neutral Processes

## – Risk-Neutral Itô Process: dS = (r − δ)dt + σdZ̃

∗ dZ̃ = dZ + ηdt
α−r
· where η = σ

∗ E ∗ [Z̃(T )] = 0
∗ E ∗ [Z(T )] = r−α

σ
T
∗ E[Z(T )] = 0
α−r

∗ E[Z̃(T )] = σ
T

• Valuing a Forward on S a

1 2 a(a−1)]T
– E[S(T )a ] = S0a e[a(α−δ)+ 2 σ

18
1 2 a(a−1)]T
– F0,T (S a ) = S0a e[a(r−δ)+ 2 σ
P
– F0,T (S a ) = e−rT · F0,T (S a )

## • Itô Process for S a

dS
– If C = S a and S
= (α − δ)dt + σdZ then

1
∗ dC
C
= (a(α − δ) + σ 2 a(a − 1) + δ ∗ ) dt + σadZ
| 2 {z }
γ

## · δ ∗ ∼ derivative’s dividend yield

γ−r α−r
∗ ⇒ Sharpe Ratios = aσ
= σ

· ⇒ γ = a(α − r) + r

• Stochastic Integration

## – Regular Calculus Rules Apply (e.g. FTC)

RT
1. 0
dZ(t) = Z(T ) − Z(0) ∼ N (0, T )
RT RT
2. 0
(dZ(t))2 = 0 dt = T − 0 = T
RT
3. 0
(dZ(t))n = 0, n > 2
RT
4. S(t) = 0 sZ(s)ds ⇒ dS = t · Z(t)dt
RT R  R 0
T T
5. S(t) = 0 tdZ(s) ⇒ dS = dt 0 dZ(s) + t 0 dZ(s) =
Z(t)dt + tdZ(s)

• Ornstein-Uhlenbeck Process

## – DE: dX = λ(α − X(t))dt + σdZ

Rt
– Integral: X(t) = X0 e−λt + α(1 − e−λt ) + σ 0
eλ(s−t) dZ(s)

• Misc. Notes

19
– volatility of S n is n · σ (remember when working with Black-
Scholes)

## • Ft,T (P (T, T + s)) ∼ forward price @ t for an agreement to buy a bond

@ T maturing @ T + s

P (t,T +s)
– Ft,T (P (T, T + s)) = P (t,T )

• Binomial Trees

## • The Black-Derman-Toy model

1
– Bond Price = (1+R)n

## – Ratio between interest rates @ successive nodes is constant

∗ it is e2σt h

 
1 Ru
2
ln Rd
– σ= √
h
 
2 year Bond Price 1 1 1
– 1 year Bond Price
= 2 1+R1
+ 1+R1 e2σ

## • Pricing Caps using BDT

20
– Discount difference due to cap by the discount rate appropriate
to the beginning of the year
 
T −KR
– Cap pays max 0, R1+R T

– For multiple year trees, start @ end and calculate the value then
weigh the results and add in the additional cap values as you
move to t0

## • P (F, P (0, T ), σ, T ) = P (0, T )(KN (−d2 ) − F N (−d1 ))

F
ln( K )√+ 12 σ2 T √
– where d1 = σ T
and d2 = d1 − σ T

## • Pricing Caps with the Black Formula

1
– (1 + KR ) Puts with strike price 1+KR

– Calculate @ each node and then add together and multiply the
sum by (1 + KR )

## • Eq. Models - Theory

dP
– dr = a(r)dt + σ(r)dZ and P
= α(r, t, T )dt − q(r, t, T )dZ

## ∗ ⇒ dP = α(r, t, T )dt − q(r, t, T )dZ, where

· α(r, t, T ) = P1 a(r)Pr + 21 σ 2 (r)Prr + Pt


· q(r, t, T ) = P1 Pr σ(r)

21
• Black-Scholes equation for Bonds

## – dr = (a(r) + σ(r)φ)dt + σ(r)dZ̃

– Z̃(t) = Z(t) − φ

## • The Rendelman-Barter Model(GBM)

– dr = ardt + σrdZ

## – P (r, t, T ) = A(t, T )e−B(t,T )r

– a 6= 0

22
2 σ2
∗ A(t, T ) = er̄[B−(T −t)]−B 4a

1−e−a(T −t)
∗ B(t, T ) = a
φ 1 σ 2

∗ r̄ = b + σa − 2 a

– a=0
3
1 2 +σ 2 (T −t)
∗ A(t, T ) = e 2 σφ(T −t) 6

∗ B(t, T ) = T − t

– ∆ = Pr = −BP

– Γ = Prr = B 2 P

## • The Cox-Ingersoll-Ross Model

– dr = a(b − r)dt + σ rdZ

– φσ = φ̄r

## – P (r, t, T ) = A(t, T )e−B(t,T )r

h i 2ab2
2γe(a−φ̄+γ)(T −t)/2 σ̄
– A(t, T ) = (a−φ̄+γ)(eγ(T −t) −1)+2γ

## 2(eγ(T −t) −1)

– B(t, T ) = (a−φ̄+γ)(eγ(T −t) −1)+2γ

p
∗ where γ = (a − φ̄)2 + 2σ̄ 2

• Misc. Notes

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– Vasicek

P

• Delta Hedging

(r,0,T2 )

(r,0,T2 )

## ∗ where numerator is what you are hedging

• Delta-Gamma-Theta Approximation

– P (r + , 0, t + h) = P (r, 0, t) + ∆ + 12 Γ2 + θh

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