A&J Flashcards For SOA Exam MFE/ CAS Exam 3F

A&J Flashcards for
Exam MFE/3F
Spring 2010
Alvin Soh
Outline
DM chapter 9 Parity and Other Option Relationship
DM chapter 10&11 Binomial Option Pricing
DM chapter 12 The Black-Scholes Formula
DM chapter 13 Market-Making and Delta-Hedging
DM chapter 14&22 Exotic Options
DM chapter 18 The Lognormal Distribution
DM chapter 19 Monte Carlo Valuation
DM chapter 20&21 Brownian Motion and Itô’s Lemma
DM chapter 24 Interest rate models
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DM Chapter 9- Parity and Other Option Relationship
Put-call parity for European Options
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C  K , T   P  K , T   e rT  F0,T  K  or
C  K , T   P  K , T   S0e T  Ke rT or
C  K , T   P  K , T   S0  PV0,T  Div   Ke rT
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Put –call parity for American Options
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C  K  PV  Div   S  P  C  PV  K   S or
P  S  PV  K   C  P  S  PV  Div   K
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Create synthetic stock by applying put-call parity when the stock pays
discrete dividends.
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S0  C  K , T   P  K , T   PV0,T  Div   Ke rT
This means that a stock is equivalent to:
1. Purchasing a $K-strike call option;

2. Selling a $K-strike put option;
3. Lend PV0,T  Div   Ke at risk-free rate.
 rT
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Create synthetic stock by applying put-call parity when the stock pays
continuous dividend.
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S0  e T  C  K , T   P  K , T   Ke rT 
This means that a stock is equivalent to:
1. Purchasing e T unit of $K-strike call option;

2. Selling e T unit of $K-strike put option;
  r T
3. Lend Ke at risk-free rate.
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Given that K1  K 2  K3 ,
C  K1   C  K 2  C  K 2   C  K3 
1. 
K 2  K1 K3  K 2
P  K1   P  K 2  P  K 2   P  K3 
2. 
K 2  K1 K3  K 2
To exploit the mispricing,
1. Sell n units of C  K 2  or P  K 2  ;
K3  K 2
2. Buy n units of C  K1  or P  K1  ;
K3  K1
K  K1
3. Buy 2 n units of C  K3  or P  K3 
K3  K1 .
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DM Chapter 10 & 11- Binomial Option Pricing
The amount of money lent, B to replicate an European option under

binomial pricing model
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 uC  dCu 
B  e rh  d 
 u  d  
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The risk-neutral probability that the underlying stock price will move to Su
on the date of expiry of the option
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e
r   h
d
p 
*
ud
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1. One plus the rate of capital gain on the stock if it goes up in

binomial pricing model, u ;
2. One plus the rate of capital loss on the stock if it goes down in
binomial pricing model, d .
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u  e 
r  h  h
1.
2. d  e r  h h
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The value of the option at a node for:
1. An American call;
2. An American put.
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1. Call  S , K , t   max  K  S , Cu p*  Cd 1  p* 
2. Put  S , K , t   max  K  S , Pu p*  Pd 1  p* 
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DM Chapter 12- The Black Scholes Formula
The assumptions of Black-Scholes formula
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1. The continuously compounded returns on the stock are normally

distributed and independent over time;
2. The volatility of continuously compounded return is known and
constant;
3. The future dividends are known, either as a dollar amount or as a
fixed dividend yield;
4. The risk-free rate is known and constant;
5. There are no transaction costs or taxes;
6. It is possible to short-sell costlessly and borrow at the risk-free rate.
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Call option premium under the assumption of Black-Scholes Framework,

given that the stock pays dividend as a fixed dividend yield
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C  Se T N  d1   Ke rT N  d2 
where
 Se T  1
ln   rT    2
1. d1 
 Ke  2
 T
2. d2  d1   T
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DM Chapter 14 & 22- Exotic Options
CallOnCall  PutOnCall  BSCall  xe rt1
CallOnPut  PutOnPut  BSPut  xe rt1
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Black Scholes pricing formula for Gap options:
1. Call option with strike price K1 and trigger price K 2 ;

2. Put option with strike price K1 and trigger price K 2 .
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1. Call  Se T N  d1   K1e rT N  d2 

2. Put  K1e rT N  d2   Se T N  d1 
where
  r    0.5 2  T
S
ln
K2
1. d1 
 T
2. d2  d1   T
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DM Chapter 19- Monte Carlo Valuation
 1 2
      h  hZ  n 
Snh  S n1h e  2 
or
 1 2  1 n 
     T  h 
 2   n
 Z i 
ST  S0e i 1 
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Monte Carlo Valuation of plain vanilla options:
1. Call option;
2. Put option.
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1 N   r   12 2 h  hZ  i  
1. C e  rT
 max  S0e 
 K , 0
N i 1  
1 N   1 2
 r     h  hZ  i  
2. Pe  rT
 max  K  S0e  2 
, 0
N i 1  
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DM Chapter 20 & 21- Brownian Motion, Itô’s Lemma
Definition of Brownian Motion
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DM Chapter 20 & 21- Brownian Motion, Itô’s Lemma
1. Z  0  0 ;
2. Z t  s   Z t  N  0, s  ;
3. Z  t  s1   Z  t  is independent of Z  t   Z  t  s2  ;
4. Z  t  is continuous;
 
5. A martingale: E Z  t  s  | Z  t   Z  t  .
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A&J Flashcards For SOA Exam MFE/ CAS Exam 3F

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A&J Flashcards for

DM chapter 10&11 Binomial Option Pricing

DM chapter 12 The Black-Scholes Formula

DM chapter 13 Market-Making and Delta-Hedging

DM chapter 14&22 Exotic Options

DM chapter 18 The Lognormal Distribution

DM chapter 19 Monte Carlo Valuation

DM chapter 20&21 Brownian Motion and Itô’s Lemma

DM chapter 24 Interest rate models

Put-call parity for European Options

C  K , T   P  K , T   S0  PV0,T  Div   Ke rT

Put –call parity for American Options

S0  C  K , T   P  K , T   PV0,T  Div   Ke rT

This means that a stock is equivalent to:

1. Purchasing a $K-strike call option;

This means that a stock is equivalent to:

1. Purchasing e T unit of $K-strike call option;

To exploit the mispricing,

The amount of money lent, B to replicate an European option under

1. One plus the rate of capital gain on the stock if it goes up in

The value of the option at a node for:

1. Call  S , K , t   max  K  S , Cu p*  Cd 1  p* 

2. Put  S , K , t   max  K  S , Pu p*  Pd 1  p* 

The assumptions of Black-Scholes formula

1. The continuously compounded returns on the stock are normally

Call option premium under the assumption of Black-Scholes Framework,

CallOnCall  PutOnCall  BSCall  xe rt1

CallOnPut  PutOnPut  BSPut  xe rt1

Black Scholes pricing formula for Gap options:

1. Call option with strike price K1 and trigger price K 2 ;

1. Call  Se T N  d1   K1e rT N  d2 

Monte Carlo Valuation of plain vanilla options:

Definition of Brownian Motion

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