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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 theorem

E U

[

A

]

[

> EU

B

]

Ch3, p9-10

Portfolio theory (minimum variance portfolio with 2 assets)

 

V

B

-

C

AB

Ch5, p9

x =

A

VV

A

+

B

- 2

C

AB

Portfolio theory (variance with N assets)

V

=

V

*

+

N -

1

C *

Ch5, p22

N

N

Multi-factor models (orthogonal factors)

*

I

1

= I , I =-I (g +g I )

1

2

2

1

21

*

*

 

Ch6, p7-8

Single-index model (moments)

E

i

= a + b E ,

i

iM

C =bb V

ij

i

j

M

V

i

=b

VV e

iM

+

i

2

,

Ch6, p10

Arbitrage pricing theory (expected returns)

E i =ll+ bb+l ++l b

0

1

i ,1

2

i ,2

L iL,

 

Ch7, p16-17

Brownian motion (covariance formula)

cov(

B B

s

,

t

)

=

min(

st

,

)

 

Ch8, p6

Brownian motion (scaling and time- inversion properties)

B 1 ( )

t

=

1

c
c

B

ct

,

B

2

( )

t = tB

1 t

Ch8, p6-7

Brownian motion is not differentiable

Consider (

a - d ) sB< <+a ( d ) s

s

 

Ch8, p8-9

Stochastic integrals (distribution)

b

Ú

a

f s dB

(

)

s

~

N

Ê

Ë

0,

b

Ú

a

[

f s

(

)

]

2

ds

ˆ

¯

Ch9, p9,27

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© IFE: 2015 Examinations

Page 2

CT8: Proofs

Topic

Formula

Where?

Solving SDEs (Geometric BM and the O-U process)

Ch9, p21-22,

26-27

Forward contracts (formulae for forward prices)

rT

Ch11, p16

F

0

= Se

0

[Proof (b)]

European options (put- call parity)

c

t

+

Ke

rT()t

--

=+

p

S e

tt

qT()t

--

 

Ch11, p23-25

Binomial tree (the no- arbitrage inequality)

de<

r

< u

Ch13, p6

Multi-step binomial tree (general pricing formula)

n

- t

Ê

Á Ë

n

-

k

t

ˆ

˜ ¯

q

 

Ch13, p32

V

t

=

e

-

(

rnt

-

)

Â

(

f Su d

t

k

nt k

--

)

k

(1

-

q

)

--

nt k

 
 

k

= 0

   

Binomial trees

(calibration)

u

=

t
t

e s d

,

d

=

t
t

e -s d

Ch13, p34-36

Black-Scholes (PDE)

Q+ r - q S D+ s S G= rf

(

)

t

2

t

1

2

2

 

Ch14, p10-20

MRT (discrete time)

D=DY f X

t

tt

Ch15, p14-17

“5-step proof” (continuous time)

V

t

=

e

-

(

rT t

-

)

EX

[

|

QTt

F

]

Ch16

Two-state model (pricing a bond)

(

B t T

,

)

=

e

-

(

rT t

-

)

E

Q

È

Î

1

--

(1

d

)

(

1

-

exp

(

-

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

V

t

=

e

-

(

rT t

-

)

EX

[

|

QTt

F

]

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

© IFE: 2015 Examinations

The Actuarial Education Company