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Mathematical Finance Cheat Sheet
Mathematical Finance Cheat Sheet
1
1
(x ) = p
exp (x )0Q 1 (x ) , x Rn .
2
(2)n detQ
We write X N(,Q ) if this is the case. Alternatively, X N(,Q ) under P if and
only if
1
0
EP [e X ] = exp 0 + 0Q , for all Rn .
2
If Z N(0,Q ) and c Rn then X = c 0 Z N(0, c 0Q c ). If C Rmn (i.e., m n matrix)
0
0
then X = C Z N(0, C Q C ) and C Q C is a m m covariance matrix.
Gaussian Shifts
If Z N(0, 1) under a measure P, h is an integrable function, and c is a constant
then
2
EP [e c Z h (Z )] = e c /2 EP [h (Z + c )].
Let X N(0,Q ), h be a integrable function of x Rn , and c Rn . Then
EP [e c
h (X )] = e
1
2
c 0Q c
Cameron-Martin-Girsanov Converse
If (W (t ))t 0 is a P-Brownian motion, and Q is a measure equivalent to P, then there
exists a F -previsible process ((t ))t 0 such that
Z t
f(t ) := W (t ) +
(s ) d s
W
0
ZT
dQ
1
(t ) d W (t )
= exp
(t )2 d t .
dP
2 0
0
Martingale Representation Theorem
EP [h (X + c )].
ZT
1
EP exp
(s )2 d s < X is a martingale.
2 0
Its Formula
f(t ).
d X (t ) = (t ) d t + (t ) d W (t ), d Y (t ) = (t ) d t + (t ) d W
Then d (X (t )Y (t )) = X (t ) d Y (t ) + Y (t ) d X (t ) as d X , Y (t ) = 0.
Radon-Nikodm Derivative
Given P and Q equivalent measures and a time horizon T , we can define a random
variable dd QP defined on P-possible paths, taking positive real values, such that
dQ
EQ [X T ] = EP
X T , for all claims X T knowable by time T ,
dP
[t X t |Fs ], for s t T ,
EQ [X t |Fs ] = 1
s EP
where t is the process EP [ dd QP |Ft ].
Cameron-Martin-Girsanov Theorem
If (W (t ))t 0 is a P-Brownian motion and
((t
R))Tt 0 is an F
-previsible process satisfying the boundedness condition EP exp 12 0 (t )2 d t < , then there exists a
measure Q such that:
Q is equivalent
P,
Z to
ZT
T
dQ
1
= exp
(t ) d W (t )
(t )2 d t ,
dP
2 0
0
R
f(t ) := W (t ) + t (s ) d s is a Q-Brownian motion.
W
0
i (s )0 j (s ) d s ,
X i , X j (t ) =
xi
i =1
+
n
1 X 2f
(t , X 1 (t ), . . . , X n (t ))d X i , X j (t ).
2 i , j =1 xi x j
n
1 X 2 fk (t , X (t ))
d X i , X j (t ).
2 i , j =1 xi x j
Stochastic Exponential
The stochastic exponential of X is Et (X ) = exp(X (t ) 21 X (t )). It satisfies
E (0) = 1, E (X )E (Y ) = E (X + Y )e X ,Y , E (X )1 = E (X )e X ,X .
The process Z = E (X ) is a positive process and solves the SDE
Z (0) = e X (0) .
dZ =Z dX ,
(t )(t ) d t
In the other case, if X (t ) and Y (t ) are adapted to two different and independent
f(t ))t 0 ,
Brownian motions (W (t ))t 0 and (W
(s ) d W (s ),
g
g
1
2g
(t , X t ) d t +
(t , X t ) d X t + (t )2
(t , X t )d t .
t
x
2
x2
The Product Rule
(s ) d s +
(s ) d M (s ),
z (t ) = t +
z (a ) = ,
t := exp
= exp
(u ) d u ,
a
Z
(u) d u +
a
m (u ) exp
(r ) d r d u .
u
Z (t ) = Et +
Z (a ) = ,
Et Eu1 q (u) d W (u ),
where Et := Et (X ) and X (t ) =
Z t
Rt
a
(u ) d u +
Z t
(u) d u +
Et = exp
Rt
(u )d W (u ). In other words,
Z t
1
(u) d W (u)
(u)2 d u .
2 a
a
ZT
r (s ) d s X Ft ,
V (t ) = EQ exp
ZT
(t ) :=
t f 0 (X t ) + 12 2t f 00 (X t ) r f (X t )
,
t f 0 (X t )
and the behaviour of X t under the risk-neutral measure Q is given by
f(t ) +
d X (t ) = (t )d W
r f (X t ) 12 2t f 00 (X t )
f
0 (X
t)
Consider a European option with strike price K on a asset with value VT at maturity time T . Let FT be the forward price of VT , F0 the current forward price. If
log VT N(F0 , 2 T ) then the Call and Put prices are given by
C = P (0, T )(F0 (d 1 ) K (d 2 )), P = P (0, T )(K (d 2 ) F0 (d 1 )),
The forward rate at time t that applies between times T and S is defined as
P (t , T )
1
log
.
F (t , T,S ) =
S T
P (t ,S )
The instantaneous forward rate at time t is f (t , T ) = limS T F (t , T,S ). The instantaneous risk-free rate or short rate is r (t ) = limT t f (t , T ). The cash account is
given by
Z t
r (s ) d s ,
log P (t , T ), R (t , T ) =
.
f (t , T ) =
T
T t
Conversely,
ZT
f (t , u) d u
and
1b X
((a + i v b , X 0 , T )e i v y )
dv
v
The i th entry in X is the log asset price and k = l o g (K ), the log strike. d is a vector
whose i th element is 1, else zero. The corresponding call option price is
C = G (d , d , k ) K G (0, d , k )
The Heath-Jarrow-Morton Framework
Given a initial forward curve T 7 f (0, T ) then, for every maturity T and under the
real-world probability measure P, the forward rate process t 7 f (t , T ) follows
Z t
Z t
(s , T )0 d W (s ),
(s , T ) d s +
f (t , T ) = f (0, T ) +
t T,
r (t ) = f (t , t ) = f (0, t ) +
(s , t ) d s +
(s , t ) d W (s ),
so the cash account and zero coupon T -bond prices are well-defined and obtained
through
ZT
Z t
r (s ) d s ,
P (t , T ) = exp
P (t , T ) = exp((T t )R (t , T )).
f (t , u) d u .
P (t , T ) = exp
(a , X 0 , T ) 1
B (t ) = exp
p
log(EQ (VT )/K ) + 2 T /2
and d 2 = d 1 T .
p
T
B (t ) = exp
XT
dt.
Blacks Model
where d 1 =
R (X s )d s e a
G (a , b , y ) = EQ exp
d Z (t , T ) = Z (t , T )
(t , u) d u d t + S (t , T )0 d W (t ) ,
S 2 (t , T )
2
t
|
{z
}
b (t ,T )
where S (s , T ) :=
RT
s
f(s ),
f (t , T ) = f (0, T ) +
(s , T ) d W
(s , T )
(s , u)0 d u d s +
s
{z
HJM drift
For a tenor > 0, the LIBOR rate L (T, T, T + ) is the rate such that an investment
of 1 at time T will grow to 1+L (T, T, T +) at time T +. The forward LIBOR rate
(i.e., a contract made at time t under which we pay 1 at time T and receive back
The state vector X t follows a Markov process solving the SDE
1 + L (t , T, T + ) at time T + ) is defined as
d X t = (X t )d t + (X t )d Wt + d Z t
P (t , T )
1
where W is an adapted Brownian, and Z is a pure jump process with intensity .
L (t , T ) := L (t , T, T + ) =
1 ,
P (t , T + )
The moment generating function of the jump sizes is (c ) = EQ (exp(c J )). Impose
an affine structure on , T , and the discount rate R , possibly time dependent: and satisfies L (T, T ) = L (T, T, T + ).
Under the real-world probability measure P, The LMM assumes that each LIBOR
(x ) = K 0 +K 1 x ((x )(x )T )i j = (H0 )i j +(H1 )i j x (x ) = L 0 +L 1 x R (x ) = R0 +R1 x process (L (t , Tm ))0t T satisfies
m
Given X 0 , the risk neutral coefficients (K , H , L , , R ) completely determine the disd L (t , Tm ) = L (t , Tm ) (t , L (t , Tm )) d t + m (t , L (t , Tm ))0 d W (t ) ,
counted risk neutral distribution of X . Introduce the transform function
ZT
, u) =K 0T (t , u) + 21 (t , u)T H0 (t , u) + L 0 ( ( (t , u)) 1) R0
(t
AJD bond pricing
r =m +1
K0
(t )
(t )
(t )(t )
)
(t )(t
K1
(t )
(t )
n
X
d L (t , Tm ) = L (t , Tm ) (t , Tm )
Tr ,Tr +1 (t )0 d t + (t , Tm )d W m (t )
H0
2
2
2
2
2
(t )2
(t )2
H1
2
2
2
P?MR?
NN
YN
NY
YY
YY
NN
NY
NY
YY
P means the process stays positive, MR means rt is mean-reverting. Closed form solutions for bond prices and European options exist for all models except for , which
describes the evolution of d log(rt ) instead of d rt .
For m = n,
and for m > n we have
d L (t , Tm ) = L (t , Tm )(t , Tm )d Wt m
d L (t , Tm ) = L (t , Tm ) (t , Tm )
m
X
r =n+1
Tr ,Tr +1 (t )0 d t + (t , Tm )d Wt m
github.com/daleroberts/math-finance-cheat-sheet