Financial Markets 2015-2016

Formula Sheet

Equities
Notations :
rf risk-free rate
ri return of asset i
i = E[ri ] expected return of asset i ; = E[P1 + D1 ]/P0 1
2
i = var[ri ] variance of asset i
i volatility/risk/standard deviation of asset i
ij = ij i j covariance between assets i and j
ij 0 1 correlation between assets i and j
1
B C
= @ ... A vector of expected returns of N risky assets, N 1
0N2 1
1 12 ... 1N
B .. C
B . 2 ... ... C
=B
B ..
2
..
C
C variance-covariance matrix, N N
@ . . A
... ... 2
0 1N1 N
w1
B .. C
w=@ . A vector of weights/proportions invested in N risky assets, N 1
wN
The covariance between two portfolios P1 and P2, composed of assets A and B, is :

P1 P2 = cov(rP1 + rP2 ) = cov(w1A rA + w1B rB , w2A rA + w2B rB )

= w1A w2A 2 + w1A w2B + w2A w1B + w1B w2B 2
A AB AB B

We denote by E[rM ] = M the expected market return. The CAPM implies :

im
i = rf + (m rf ) 2
= rf + (m rf ) i
m
cov(ri , rM )
i =
var(rM )
The APT implies :

i = rf + i1 1 + i2 2 + + iK K

where 1, 2, ..., K are the factor premia.

Performance measures (Sharpe Ratio, Treynor Ratio, Jensens Alpha) :

i rf
SRi =
i
i rf
T Ri =
i
i = i rf i (M rf )

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Derivatives
Options payos at expiration :
(
ST K if ST > K
CallT = max(0, ST K) =
0 if ST < K
(
0 if ST > K
P utT = max(0, K ST ) =
K ST if ST < K
where ST is the underlying stock price at expiration date and K is the strike price.
The risk neutral probability is :

S0 (1 + rf ) Sd
=
Su Sd
Call price (same for put price) :

Cu + (1 )Cd
C=
1 + rf

Put-call parity :
K
Ct Pt = S t
(1 + rf )T t

Put-call parity with dividends :

Ct Pt = S t P V (K) P V (div)

where P V (.) denotes the present value.

The hedge ratio (the delta) :

h = (Pu Pd )/(Su Sd ), for puts or

h = (Cu Cd )/(Su Sd ), for calls

Pricing equations for the Black-Scholes-Merton model :

rT
C0 = S0 N (d1 ) K e N (d2 )
rT
P0 = K e S0 + C0 = K e rT N ( d2 ) S0 N ( d 1 )
1
d1 = p ln(S0 /K) + (r + 2 /2) T
T
p
d2 = d1 T

where :
N () is the cumulative distribution function of the standard normal distribution
T is the time to maturity
S0 is the spot price of the underlying asset
K is the strike price
r is the risk free rate (annual rate, expressed in terms of continuous compounding)
is the volatility of returns of the underlying asset

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The Greeks for call options :

@C
Delta = = = N (d1 )
@S
2
@ C N 0 (d1 )
Gamma = = = p
@S 2 St
@C p
V ega = = = St N 0 (d1 )
@
@C St N 0 (d1 ) r
T heta = = = p rKe N (d2 )
@t s
@C
Rho = = = Ke r N (d2 )
@r
The Greeks for put options :
@P
Delta = = = N (d1 ) 1
@S
@2P N 0 (d1 )
Gamma = = = p
@S 2 St
@P p
V ega = = = St N 0 (d1 )
@
@P St N 0 (d1 ) r
T heta = = = p + rKe N ( d2 )
@t s
@P
Rho = = = Ke r (N (d2 ) 1)
@r
2
e px /2
where N 0 (x) = 2
.

Bonds
Present value of future cash-flows is :
T
X CFt
PV =
(1 + rt )t
t=1

where CFt is the cashflow at date t and rt is the spot rate with a maturity of t periods.

Coupon bonds pricing :

T
X X T
C F C F
P = + = +
(1 + rt )t (1 + rt )t (1 + y)t (1 + y)t
t=1 t=1

where y is the yield to maturity of the bond, F is the face value, and C is the coupon.

Price of a zero-coupon bond of maturity T and face value F is :

F F
B0 (T ) = =
(1 + rT )T (1 + y)T
Forward rates :
(1 + rn )n (1 + fn,m )m n = (1 + rm )m
1/n 1/n
B0 (t) (1 + rt+n )t+n
ft,t+n = 1= 1
B0 (t + n) (1 + rt )t

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The duration is :
T
P 1+y 1 X t CFt
D= =
P y P (1 + y)t
t=1

The modified duration is :

T
D 1 P 1 1 X t CFt
D = = =
1+y P y P 1+y (1 + y)t
t=1

The percentage change in the price is :

P
= D y
P
The convexity is :
2P T
X
1 1 1 t(t + 1)CFt
C= =
P y2 P (1 + y) 2 (1 + y)t
t=1

The percentage change in the price when the convexity is taken into account is :
P 1
= D y + C( y)2
P 2
Swap pricing at initiation, pay fixed and receive floating :

V S = Vf loating Vf ixed
T
X days
Vf ixed = R B0 (t) + B0 (T )
360
t=1
Vf loating = 1, at t=0 or payment date
!
360 1 B0 (T )
R= PT
days t=1 B0 (t)