S = ( ) dt + dZ (t)

then

d (S a )
=
Sa



a (a 1) 2
a ( ) +
dt + adZ (t)
2


Forward:

a(r)+

F0,T (S a ) = S (0) e


P
F0,T

(S ) = e

rT

a(r)+

S (0) e

a(a1) 2
2

a(a1) 2
2


T


T

r
r
=
C = Sa,
a


a 


2
S (t)
t as w +(1a) r+ a
2
W (t) = W (0)
e
S (0)
For

Proportional

dX1
X1
dX2
X2

AT/ADD/Lara/Halfass

dX
r
= ( ) dt + dZ =
Sign of the denominator is important
X

c1 X1 (0) 1 + c2 X2 (0) 2 = 0
= (1 1 ) dt + 1 dZ
then risk free
or

= (2 2 ) dt + 2 dZ

c1 X1 (0) 1 + c2 X2 (0) 2 = c1 X1 (0) r + c2 X2 (0) r



( ) dt + dZ = ( ) dt + dt + dZ =

Cr = CS S (r ) +

Black-Scholes Equation


dt + (dt + dZ) = (r ) dt + dZe
S 2 2 CSS
+
2

Ct+h Ct = 4 +

Delta-gamma-theta approximation

2
+ h
2

ito's lemma:

Rehedging: Period variance:

dC = CS dS +
1 2 2
2
S v
2

CSS (dS)
+ Ct dt
2

and Annual variance:

No Prot Threshold:
Martingale

If

dS
= ( ) dt + dZ
S

1 2 2
2
S v n
2

Sv

dt's coecient is 0

t,T
dF
Ft,T = ( r) dt + dZ
then

dFPt,T = dt + dZ
F
t,T

Arithmetic Brownian

X (t) = X (0) + t + Z E [t] = X (0) + t Cov (X (t) , X (t + h)) = 2 t Var (X (t)) = 2 t

Geometric

X (t) = X (0) e

Call
Put
Comment

 2

dX
= dt + dZ Cov (X (u) , X (t)) = E [u] E [t] e t 1
X





2

2
d ln X (t) =
dt + dZ ln X (t) = ln X (0) +
t + Z
2
2

E [X (t)] = X (0) et



2
2 t+Z

= CS
> 0, N (d1 ) eT
< 0, N (d1 ) eT
S shaped

= CSS
> 0,

Vega

> 0,

same

Symmetric Hump
Stock:

same

Assymetric Hump

4 = 1,

C
C
S
S

<0

usually, dierent

Upside-Down Hump

all other Greeks are

S
C
S
S

Rho

(r)

> 0,
< 0,

up

Psi

< 0,
> 0,

up

Multiply by

0.01

==

()
down
down

Multiply by

S
S
C = S pay attention to signs of
C
C


X
Stotal total
portfolio: simple sum based on shares Ftotal =
ni Fi vs Elasticity for portfolio:
Ctotal

Historical Volatility (assumes daily/weekly/monthly/quarterly return is 0): Sx n

1, Sx

2, x

Estimate Annual :



S2

3, Annual = x
+ x n

Elasticity: Instantaneous

Greek for

r
r

Theta

0.01



PtEuropean
+ CTAmerican CtEuropean
= CallonPut
1
1

U = S22 S44 S88


then

U=

S8
S4

8 

S4
S2

12 

S2
S0

14

whose strike is

S014 ln U = 8 ln



D K 1 e(T t1 )r

S8
S4
S2
+ 12 ln
+ 14 ln
+ 14 ln S0
S4
S2
S0

Var (ln U )

= 64 4 + 144 2 2 + 196 2 2 = 936 2

Cost of Hedge: accumulated sum of cost

Cov (X, Y

)=

Correlation
Var (aX
Var (ln X

+ bY ) = a

(
x xi ) (
y yi )

==

Var (X)

+b

Cov (X, Y

x y
Var (Y

) + 2abCov (X, Y )

2
ln Y ) = Var (ln X) + Var (ln Y ) 2Cov (ln X, ln Y ) 2 = X
+ Y2 2X Y

Binomial trees (Forward tree unless specied otherwise)

Cox-Ross-Rubinstein

ev

d
p

ev

Forward

Lognormal/Jarrow-Rudd

Future

Future (when based on forward prices)



2
r 2 h+v
e

2
r 2 hv

ev

e(r)h+v

e(r)hv
e
e(r)h d

p = ud
u d
u Cd h
= C
and =
SuSd e
SuSd

d
1d

p = ud
Cu Cd
4 = F uF d

ev
and

1d
1
p = ud
= 1+u
rh

B=C=e
(p Cu + (1 p ) Cd )

Ceh = S4eh + Berh C = eh (ptrue Cu + (1 ptrue ) Cd ) C = erh (p Cu + (1 p ) Cd )

Cerh = S4erh + Berh C = S4 + B
=0

Call

Put

American=European

American>European

CEU 0, T, Ke

U = Called
(

Qu = ptrue Uu
Qd = (1 ptrue ) Ud

Option


r(T t)

CEU (0, t, K)

Marginal Value or Utility

(Qu + Qd ) (1 + reective ) = 1 p =

Qu
S0 = Qu Su + Qd Sd
Qu + Qd

P E (St | St > K) = S0 e(r)t N (d1 )

Pr (St

if C = C (S | S > K)

if C = C (S | S < K)

then

> K) = N (d2 )

Cert = S0 e(r)t N (d1 )

and

Cert = S0 e(r)t N (d1 )

and

4et = N (d1 ) +

1
e v 2 2
q
1
2
ed1 v 2 2
d2
1

4et = N (d1 )
q
4 can be
1
rt

and 4e
=K

if C = C (K | S > K) then Cert = KN (d2 )

d2

e 2 S 2 v 2 2

1
rt

if C = C (K | S < K) then Cert = KN (d2 )

and 4e
= K
2
d2 2 2
e S v 2




S
K
S
K
Vchooser = C (S, K, T ) + P
,
,
t
=
P
(S,
K,
T
)
+
C
,
,
t
e(T t) er(T t)
e(T t) er(T t)
then

S0 e(r)T N (d1 ) S0 e(r)t N (d2 ) = Cforward start erT Forward

zj = 6 +

12
X

ui

or

z = N 1 (u)

where

Start option:

uniform, then

more than

K = S0 e(r)t

e+z

i=1

Anthetic:

uses

Stratied Sampling:

Break down into intervals, then scale into them in the given order

Non-Control:
Control:

Control Variate:
Boyle Modication:

Y
X

Y = y + (E (x) x
) Var (Y ) = Var (
y ) + Var (
x) 2Cov (
x, y)

Y = y + a (E (x) x
) Var (Y ) = Var (
y) + a

Var (
x)

2aCov (
x, y)

Naive variance must be multiplied with

1
n1

where Cov (
x, y)

where

a=a

=r

in TI

and Cov (
x, y)

=r

in TI

Variance/Covariance used, if not given by the calculator, are just the naive variance, so they must be multiplied with

a=

Var (
x)
Var (Y
Take

Quadratic variation:

Cov(X,Y )

Cov (
x, y)

Var(X)
n

Cov (X, Y

Var (Control)

) = Var (
y ) 1 2XY

out of the Stochastic integral

 
2
n 
X
iT
(i 1) T
lim
X
X
n
n
n
i=1

(dX (t))

or

T
2

0 (dt)
= 0
2
T
dt2 = 0
0

2
T
dZ 2 = T
0

and

A Brownian motion has the innite crossing property: the path corsses its starting point innitely often with prob

Ornstein-Uhlenbeck

1
n1

>1

Y (t) = X (t)
dY = Y () dt + dZ

Y = Y0 et + 0 e(st) dZ
1+K

A caplet is equivalent to

puts with strike

1
1+K

Black-Derman-Toy trees: Eective Annual Rates and

dr = ardt + rdZ

P =

1
2

Rendleman

If

(
a(T t)
dr
=
a

(b

r)
dt
+
dZ
Vasicek
B = 1e a
For Vasicek
Br
P = Ae
For
and

1
r1
dr = a (b r) dt + rdZ CIR
2 = r2 with same T t
(
(

Constant for Vasicek

Constant for Vasicek

and (r) 6= r
and

(r) (r) = r For CIR

(r) = r For CIR

a(r)Pr + 21 (r)2 Prr +Pt

=
In general

2
dP
= a (b r) B + 21 (r) B 2 + PPt For Vasicek
= dt qdZ where
dr = a (r) dt + (r) dZ (t) then

P
q = PPr (r)
In general

q = B (r) and B = Pr
For Vasicek
P
(r) =

r
,
q

and CIR

and CIR

unlike before, sign of the denominator is always positive

Risk Neutral:

dr = (a (r) + (r) (r)) dt + (r) dZe (t)

b +

1 2
a 2 a
Yield-to-maturity on innity
2ab
2ab
a+a
2a2

BPS/FOAM/

2ab

a+

(a)2

2ab
a+

(a)2 +2 2

for CIR

(SOA)2
for Vasicek
2

Unless otherwise stated in the examination question, assume:

The market is frictionless. There are no taxes, transaction costs, bid/ask spreads
or restrictions on short sales. All securities are perfectly divisible. Trading does
not affect prices. Information is available to all investors simultaneously. Every
investor acts rationally and there are no arbitrage opportunities.
The risk-free interest rate is constant.
The notation is the same as used in Derivatives Markets, by Robert L. McDonald.
When using the normal distribution calculator, values should be entered with five
decimal places. Use all five decimal places from the result in subsequent calculations.
In Derivatives Markets, Pr(Z < x) is written as N(x).
The standard normal density function is
2

e x / 2
e x / 2
e x / 2
f Z ( x) = N ( x) =
=
=
,
2
2 3.14159 2.50663

< x < .

Let Y be a lognormal random variable. Assume that ln(Y) has mean m and standard
deviation v. Then, the density function of Y is

fY ( x ) =

1 ln( x) m 2
exp
,
2
v
xv 2

x > 0.

The distribution function of Y is

ln( x) m
FY ( x) = N
,
v

x > 0.

Also,
1

k
E[Y ] = exp km + k 2v 2 ,
2

which is the same as the moment-generating function of the random variable ln(Y)
evaluated at the value k.