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From Chapter 5, dollar forward price for a euro is F0,T = x0e(r −re u r o )T , where x0 is the current
exchange rate denominated as $/euro.
S > CAmer (S , K , T ) > CEur (S , K , T ) > max [0, PV0,T (F0,T ) − PV0,T (K)]
K > PAm er (S , K , T ) > PEur (S , K , T ) > max [0, PV0,T (K) − PV0,T (F0,T )]
1
2 Section 2
K1 < K2 < K3
1. C(K1) > C(K2)
2. P (K2) > P (K1)
3. C(K1) − C(K2) 6 K2 − K1
4. P (K2) − P (K1) 6 K2 − K1
C(K1) − C(K2) C(K2) − C(K3)
5. K2 − K1
> K3 − K2
P (K2) − P (K1) P (K3) − P (K2)
6. K2 − K1
6 K3 − K2
e(r −δ)h − d
p∗ =
u−d
C = e−r h[p∗Cu + (1 − p∗)Cd]
√
u = e(r −δ)h+σ√h
d = e(r −δ)h−σ h
P
F0,T (S) = S0 − PV0,T (Div)
P
F0,T (S) = x0e−rfT
δ =r
This is know as the Black Formula.
γ − r = (α − r) × Ω
1 − 1 x2
Z x
φ(x) ≡ √ e 2 N (x) ≡ φ(x)dx
2π −∞
6 Option Greeks
∂C(S , K , σ, r, T − t, δ)
∆call = = e−δ(T −t)N (d1)
∂S
∂P (S , K , σ, r, T − t, δ)
∆put = = e−δ(T −t)N ( − d1)
∂S
6.4 Vega
∂C(S , K , σ, r, T − t, δ) √
Vegacall = Vegaput = = Se−δ(T −t)N ′(d1) T − t
∂σ
∂C(S , K , σ, r, T − t, δ)
ρcall = = (T − t)Ke−r(T −t)N (d2)
∂r
∂P (S , K , σ, r, T − t, δ)
ρput = = (T − t)Ke−r(T −t)N ( − d2)
∂r
∂C(S , K , σ, r, T − t, δ)
ψcall = = − (T − t)Se−δ(T −t)N (d1)
∂δ
∂P (S , K , σ, r, T − t, δ)
ψput = = (T − t)Se−δ(T −t)N ( − d1)
∂δ
1
∆t(St+h − St) − [∆t(St+h − St) + 2 (St+h − St)2Γt + θh] − rh[∆tSt − C(St)] =
1
− 2 ǫ2Γt + θth + rh[∆tSt − C(St)]
1 2 2
2
σ St Γt + rSt∆t + θ = rC(St)
7.2 Re-hedgeing
Cu − Cd
∆(S , 0) = e−δh
uS − dS
∆(uS , h) − ∆(dS , h)
Γ(Sh , h) =
uS − dS
ǫ = udS − S
1
C(udS , 2h) − ǫ∆(S , 0) − 2 ǫ2Γ(S , 0) − C(S , 0)
θ(S , 0) =
2h
8 Exotic Options: I
max [0, ± (G(T ) − K)] where G(T ) is some sort of average and the sign depends on it being a call or
put.
K1 strike. K2 trigger.
n n
!
X X
E ωi x i = ωiµi
i=1 i=1
n n X
n
!
X X
Var ωixi = ωiω jσij
i=1 i=1 j =1
8 Section 10
E(St) = S0e(α−δ)t
Prob(St < K) = N ( − dˆ2) Prob(St > K) = N (dˆ2) where dˆ2 is the standard Black-Schoes argument
with r → α.
N ( − dˆ1) N (dˆ1)
N (St |St < K) = Se(α−δ)t N (St |St > K) = Se(α−δ)t
N ( − dˆ2) N (dˆ2)
12
X
Z̃ = ui − 6
i=1
n
1
X
V (S0, 0) = n e−r T V (STi , T )
i=1
A∗ = Ā + β(G − Ḡ )
dS(t)
S(t)
= αdt + σdZ(t)
• Z(0) = 0
• Z(t + s) − Z(t) ∼ N (0, s)
• Z(t + s1) − Z(t) is independant of Z(t) − Z(t − s2) s1, s2 > 0
• Z(t) is continuous
√
Z(t + h) − Z(t) = Y (t + h) h
h = T /n
n
" #
√ 1 X
Z(T ) − Z(0) = T √ Y (ih)
n i=1
√
dZ(t) = Y (t) dt
n
" #
√ 1 X
Z T
Z(T ) = Z(0) + lim T √ Y (ih) → Z(0) + dZ(t)
n→∞ n i=1 0
E[X(t)] = X(0)eαt
dt × dZ = 0
(dt)2 = 0
(dZ)2 = dt
dZ × dZ ′ = ρdt
dS(t)
= (α − δ)dt + σdZ(t)
S(t)
1
dC(S , t) = CSdS + 2 CS S (dS)2 + Ctdt
n o
1
dC(S , t) = [α̂(S , t) − δˆ(S , t)]CS + 2 σ̂ (S , t)2CS S + Ct dt + σ̂ (S , t)CSdZ
1
P [a(r −δ)+ 2 a(a−1)σ 2]T
F0,T [S(T )a] = e−rTS(0)ae
1
[a(r −δ)+ 2 a(a−1)σ 2]T
F0,T [S(T )a] = S(0)ae
dS
= (α − δ)dt + σdZ
S
dW = rWdt
I = V (S , t) + NS + W = 0
1
dI = dV + N (dS + δSdt) + dW = Vtdt + VSdS + 2 σ 2S 2VSSdt + N (dS + δSdt) + rWdt
dS
= (r − δ)dt + σdZ̃
S
1 1
E(dV ) = Vt + σ 2S 2VSS + (α − δ)SVS
dt 2
E ∗(dS) = (r − δ)dt
1 1 1
dt
E ∗(dV ) = Vt + 2 σ 2S 2VS S + (r − δ)SVS so dt
E ∗(dV ) = rV
13 Exotic Options: II
14 Volatility
ǫt+h = ln(St+h/St)
n
2 1
σˆH
X
= ǫ2i
(n − 1)
i=1
14.1 ARCH
Var(ǫt) = σ 2h
dP
= α(r, t)dt + q(r, t)dZ
P
dr = a(r)dt + σ(r)dZ
1 ∂ 2P 1 ∂ 2P
∂P 2 ∂P ∂P 2 ∂P ∂P
dP (r, t, T ) = dr + (dr) + dt = a(r) dr + σ(r) + dt + σ(r)dZ
∂r 2 ∂r 2 ∂t ∂r 2 ∂r 2 ∂t ∂r
1 ∂ 2P
1 ∂P 2 ∂P
α(r, t, T ) = a(r) dr + σ(r) +
P (r, t, T ) ∂r 2 ∂r 2 ∂t
1 ∂P
q(r, t, T ) = − σ(r)
P (r, t, T ) ∂r
14 Section 16
dP (r, t, T )
= α(r, t, T )dt − q(r, t, T )dZ
P (r, t, T )
Delta-hedged portfolio
dI = N [α(r, t, T1)dt − q(r, t, T1)dZ]P (r, t, T1) + [α(r, t, T2)dt − q(r, t, T2)dZ]P (r, t, T2) + rWdt
α(r, t, T ) − r
φ(r, t) =
q(r, t, T )
1 ∂ 2P ∂P ∂P
σ(r)2 2 + [a(r) + σ(r)φ(r, t)] + − rP = 0
2 dr ∂r ∂t
1 ∗
E (dP ) = rP
dt
dr = adt + σdZ
1 2 ∂ 2P ∂P ∂P
σ + [a(b − r) − σφ] + − rP = 0
2 ∂r 2 ∂r ∂t
2 2
A(t, T ) = er̄(B(t,T )+t−T )−B σ /4a
√
dr = a(b − r)dt + σ r dz
√
Sharpe Ratio: φ(r, t) = φ̄ r /σ
1 2 ∂ 2P ∂P ∂P
σ + [a(b − r) − rφ̄ ] + − rP = 0
2 ∂r 2 ∂r ∂t
" #
2γe(a− φ̄+ γ)(T −t)/2
A(t, T ) =
(a − φ̄ + γ)(e γ(T −t) − 1) + 2γ
• Pt(T , T + s) is zero-coupon bond price at time t purchased at time T and paying $1 at time T + s
16 Section 16
P (0, T )
R0(T , T + s) = −1
P (0, T + s)
1
max [0, RT (T , T + s) − KR]
1 + RT (T , T + s)
Let RT = RT (T , T + s)
R T − KR 1 1
(1 + KR)max 0, = (1 + KR)max 0, −
(1 + KT )(1 + KR) 1 + KR 1 + R T
P0(0, 1; 0) = e−r h
Pn
Using risk neutral E ∗ e− i=0rih
y(h, T , ru) √
Yield volatility = 0.5 × ln / h
y(h, T , rd)
17 Interest Rates
18 Jensen’s Inequality