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CT8: Proofs

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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 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

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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 e s d , d = 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