CT8: Proofs Page 1

Subject CT8
“Proofs”

The CT8 Core Reading contains a number of “proofs”. You may wish to make sure you
can reproduce the ones in the table below, as part of your exam preparation.

Topic Formula Where?

Stochastic dominance E [U A ] > E [U B ] Ch3, p9-10

theorem

Portfolio theory VB - C AB Ch5, p9

xA =
(minimum variance VA + VB - 2C AB
portfolio with 2 assets)

Portfolio theory V * N -1 Ch5, p22

V = + C*
(variance with N assets) N N

Multi-factor models I1* = I1 , I 2* = I 2 - (g 1 + g 2 I1* ) Ch6, p7-8

(orthogonal factors)

Single-index model Ei = a i + b i EM , Vi = b i2 VM + Ve i , Ch6, p10

(moments)
Cij = b i b j VM

Arbitrage pricing theory Ei = l0 + l1bi ,1 + l2 bi ,2 +  + lL bi , L Ch7, p16-17

(expected returns)

Brownian motion cov( Bs , Bt ) = min( s, t ) Ch8, p6

(covariance formula)

Brownian motion 1 Ch8, p6-7

B1 (t ) = Bct , B2 (t ) = tB1 t
(scaling and time- c
inversion properties)

Brownian motion is not Consider ( a - d ) s < Bs < ( a + d ) s ... Ch8, p8-9

differentiable

Stochastic integrals Ch9, p9,27

f ( s )dBs ~ N Ê 0, ds ˆ
b b
Úa [ f (s)]
2
(distribution) Úa Ë ¯

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Page 2 CT8: Proofs

Topic Formula Where?

Solving SDEs – Ch9, p21-22,

(Geometric BM and the 26-27
O-U process)

Forward contracts F0 = S0 erT Ch11, p16

(formulae for forward
prices) [Proof (b)]

European options (put- ct + Ke - r (T -t ) = pt + St e - q (T -t ) Ch11, p23-25

call parity)

Binomial tree (the no- d < er < u Ch13, p6

arbitrage inequality)

Multi-step binomial tree Ch13, p32

) ÊÁË
n - tˆ
 f (S u
n -t
- r ( n -t ) k n -t - k k n -t - k
(general pricing formula) Vt = e t
d ˜¯ q (1 - q )
k =0
k

Binomial trees u = es dt
, d = e -s dt Ch13, p34-36
(calibration)

Black-Scholes (PDE) Q + (r - q) St D + 12 s 2 St2 G = rf Ch14, p10-20

MRT (discrete time) DYt = ft DX t Ch15, p14-17

“5-step proof” Vt = e - r (T -t ) EQ [ X T | Ft ] Ch16

(continuous time)

Two-state model (pricing

a bond)
B (t , T ) = e
- r (T -t )
EQ È1 - (1 - d ) 1 - exp -
Î ( (Ú T

t
l ( s ) ds ))˘˚ Ch18, p10-11

You may also be asked to apply various other standard techniques, including:
 showing that a process is a martingale (see Ch8, p22-23)
 using a Taylor series (or Itô’s Lemma) to find the SDE for a function
 calculating the value of a derivative using a binomial tree and a replicating
portfolio and/or risk-neutral probabilities (see Ch13, p6-9)

 calculating the value of a derivative using the formula Vt = e - r (T -t ) EQ [ X T | Ft ]

 applying the Merton model to price a corporate bond (see Ch18 p6-7).

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