0.

1 Common Terminologies
The Risk-neutral assumption is the assumption that one does not expect a premium for risk. For example, an
asset with defenite payo of 50 is priced the same as an asset with an expected payo of 50.
An option is said to be in the money if it has positive payo if exercised. (Call : K < S, Put : K > S).
An option is said to be at the money if it has zero payo if exercised. (Call : K = S, Put : K = S).
An option is said to be out of the money if it has negative payo if exercised. (Call : K > S, Put : K < S).
0.2 Put-Call Prity
Call Put = F
P
(Asset) F
P
(Strike).
0.3 Option Comparison
Asset C
Amer
C
Eur
max{0, PF(Asset) PF(Strike)}.
Strike P
Amer
P
Eur
max{0, PF(Strike) PF(Asset)}.
No dividend (Europian call = American call).
No dividend Never exercise American call early.
American call on dividend paying stock is exercised early only if PV (Div) PV (Interest on K).
For an innitely lived call with no volatility, it is optimal to exercise early if S > Kr.
Call premium is a decreasing function of strike price. i.e. K
1
K
2
C(K
1
) C(K
2
).
Put premium is an increasing function of strike price. i.e. K
1
K
2
C(K
1
) C(K
2
).
Call premium has slope 1 as a function of strike price. i.e. C(K
1
) C(K
2
) (1)(K
1
K
2
).
Put premium has slope 1 as a function of strike price. i.e. C(K
1
) C(K
2
) (1)(K
1
K
2
).
Call and put premiums as functions of strike price are concave up functions.
i.e. K
1
K
2
K
3
(K
3
K
1
)C(K
2
) (K
3
K
2
)C(K
1
) + (K
2
K
1
)C(K
3
),
and (K
3
K
1
)P(K
2
) (K
3
K
2
)P(K
1
) + (K
2
K
1
)P(K
3
).
0.4 Binomial Trees
Notations: Let
S = Price of asset at time 0, O = Price of option at time 0,
S
u
= Upper node price of asset at time 1, O
u
= Upper node value of option at time 1,
S
d
= Lower node price of asset at time 1, O
d
= Lower node value of option at time 1,
u = S
u
/S, d = S
d
/S,
= Annual rate of return on the asset, = Annual rate of return on the option,
r = Annual risk free interest rate, = Annual dividend rate on the asset,
h = Time in years between time 0 and time 1, = Annual volatility of the asset,
p = True probability of upper node, p

= Risk-neutral probability of upper node.

1
No arbitrage implication: The forward price Se
(r)h
of an asset S must be between upper and lower nodes. Thus
d < e
(r)h
< u.
Binomial Tree Pricing Idea: If the asset can have only two possible future values, then an option on the asset
can be synthesized by buying of the asset and B worth of bonds (same as lending B). Thus O = S +B.
O = Option price = S +B, = number of assets to buy, B = bonds to buy, same as money to lend.
Pricing option by nding and B:
Equations to solve to get and B: O
u
= S
u
e
h
+Be
rh
, O
d
= S
d
e
h
+Be
rh
Solution is: = e
h
_
O
u
O
d
S
u
S
d
_
, B = e
rh
_
uO
d
dO
u
u d
_
.
It turns out that: O = S +B = e
rh
_
e
(r)h
d
u d
O
u
+
u e
(r)h
u d
O
d
_
.
Pricing option using Risk-neutral probability:
Risk-neutral probability p

of an up move is the solution of

Se
rh
= p

Sue
h
+ (1 p

)Sde
h
p

=
e
(r)h
d
u d
.
An option on the asset is priced using: Oe
rh
= p

O
u
+ (1 p

)O
d
O = e
rh
(p

O
u
+ (1 p

)O
d
).
It turns out that: e
rh
(p

O
u
+ (1 p

)O
d
) = e
rh
_
e
(r)h
d
u d
O
u
+
u e
(r)h
u d
O
d
_
= S +B.
Pricing option using true probability:
The true probability p of an up move is the solution of
Se
h
= pSue
h
+ (1 p)Sde
h
p =
e
()h
d
u d
.
An option on the asset is priced using: Oe
h
= pO
u
+ (1 p)O
d
O = e
h
(pO
u
+ (1 p)O
d
).
It turns out that (because of the result that the return on the option must be the weighted average of the
returns on the stocks and B bonds , i.e. e
h
=
S
S+B
e
h
+
B
S+B
e
rh
):
True prob price = e
h
_
e
()h
d
u d
O
u
+
u e
()h
u d
O
d
_
=
S +B
Se
h
+Be
rh
_
e
(r)h
d
u d
O
u
+
u e
(r)h
u d
O
d
+
e
()h
e
(r)h
u d
(O
u
O
d
)
_
=
S +B
Se
h
+Be
rh
_
e
rh
(S +B) + (e
()h
e
(r)h
)Se
h
_
=
S +B
Se
h
+Be
rh
(Se
h
+Be
rh
) = S +B
= Risk-neutral prob price.
Pricing Option using Utility:
In this section we use and r to denote eective annual rates rather than continuously compounded rates.
Marginal utility is the value of $1 given that the person has $x. Marginal utility declines as x increases.
Let U
u
and U
d
denote the current value of $1 paid at the end of the period when the stock is in state u and d
respectively.
Declining marginal utility implies U
u
U
d
.
Any amount at the upper node is pulled back using U
u
. Similarly any amount at the lower node is pulled back
using U
d
. (This is the main idea, rest follows from this)
2
p(PresVal(1) at upper node) + (1 p)(PresVal(1) at lower node) =PresVal(1)pU
u
+ (1 p)U
d
=
1
1 +rh
.
Asset prices satisfy S = pU
u
S
u
+ (1 p)U
d
S
d
and the value of the option satises O = pU
u
O
u
+ (1 p)U
d
O
d
.
Expected future value of the asset is pS
u
+(1 p)S
d
. Thus the eective annual rate of return on the asset can
be found from (1 +h)S = pS
u
+ (1 p)S
d
.
Expected future value of the option is pO
u
+ (1 p)O
d
Thus the eective annual rate of return on the option
can be found from (1 +h)O = pO
u
+ (1 p)O
d
.
Risk neutral probability is p

=
pU
u
pU
u
+ (1 p)U
d
.
Binomial Tree Pricing of Various Options:
Options on Currency: Treat domestic interest rate as r and foreign interest rate as .
Options on Futures: The forward price is the same as the current price. Hence
p

=
1 d
u d
, =
O
u
O
d
Fu Fd
, u = e

h
, d = e

h
.
Options on Stock indices: Dividends are the same as the underlying stocks.
Options on Bonds: Coupon rate serves as dividend yield. Best priced by projecting interest rates.
Miscellaneous Topics for Binomial Trees:
When a binomial tree is not given explicitly, we have the following ways to create one
Forward Tree: u = e
(r)h+

h
, d = e
(r)h

h
.
Cox-Ross-Rubinstein Tree: u = e

h
, d = e

h
.
Lognormal Tree: u = e
(r
1
2

2
)h+

h
, d = e
(r
1
2

2
)h

h
.
0.5 Lognormal Distribution and its Properties
A random variable Y is said to be a lognormal variable with parameters m and v, if Y = e
X
, where X is a normal
variable with mean m and standard deviation v.( So, lognormal = log is normal).
Mean(Y ) = e
m+
1
2
v
2
, Mode(Y ) = e
mv
2
, Median(Y ) = e
m
, V ar(Y ) = e
2m+v
2
(e
v
2
1).
The density function of Y is f(y) =
1
yv

2
e

(ln ym)
2
2v
2
.
0.6 Lognormal Model for Stock Price
The lognormal model for stock prices assumes the following: (1) Volatility is constant, (2) Stock returns for dierent
time periods are independent, (3) Large stock movements do not occur and (4) S
h+t
/S
h
is lognormal.
Under the above assumptions, let S
h+t
/S
h
be lognormal with parameters mt and v

t. Then m and v are related

to , and of the stock as follows:
By the denition of volatility , we have
2
t = V ar[ln(S
h+t
)] = V ar[ln(S
h+t
/S
h
)] = v
2
t. Thus v = .
Since E[S
h+t
] = S
h
e
()t
and E[S
h+t
/S
h
] = e
mt+
1
2
v
2
t
, we have m+
1
2
v
2
= .
Hence m and v are given by: m =
1
2

2
, v = .
Thus under the lognormal model, ln(S
h+t
/S
h
) is a normal variable with mean (
1
2

2
)t and variance
2
t
where , , and are the expected rate of return, dividend rate and volatility of the stock respectively.
3
Given that the stock price at time 0 is S
0
, we can calculate various probabilities for stock price S
t
at time t.
For example:
Pr(S
t
< K) = Pr(ln(S
t
/S
0
) < ln(K/S
0
)) =
_
ln(K/S
0
) [
1
2

2
]t

t
_
where is the distribution function of the standard normal variable.
A European put with strike price K and t years to expiry on the stock can be priced as follows: Since the density
function of a lognormal variable with parameters (
1
2

2
)t and

t is f(x) =
1
x

2
e

(ln x(
1
2

2
)t)
2
2
2
t
, the
expected payo from the put is
E[max{0, K S
t
}] = S
0
E[max{0, K/S
0
S
t
/S
0
}] = S
0
_
K/S0
0
(K/S
0
x)
1
x

2
e

(ln x(
1
2

2
)t)
2
2
2
t
dx
= K
_
K/S0
0
1
x

2
e

(ln x(
1
2

2
)t)
2
2
2
t
dx S
0
_
K/S0
0
1

2
e

(ln x(
1
2

2
)t)
2
2
2
t
dx
The rst integral is Pr[S
t
/S
0
< K/S
0
] =
_
ln(K/S0)[
1
2

2
]t

t
_
and the second integral can be rewritten as (after
the substitution y = ln x (
1
2

2
)t)
_
K/S0
0
1

2
e

(ln x(
1
2

2
)t)
2
2
2
t
dx = e
()t
_
ln(K/S0)(
1
2

2
)t

2
e

(y
2
t)
2
2
2
t
dy.
The last integral is the integral of the density function of a normal variable with mean and variance
2
t. Hence
_
K/S0
0
1

2
e

(ln x(
1
2

2
)t)
2
2
2
t
dx = e
()t

_
ln(K/S
0
) (
1
2

2
)t
2
t

t
_
Thus the expected future payo from the European put option is
E[max{0, K S
t
}] = K
_
ln(K/S
0
) [
1
2

2
]t

t
_
S
0
e
()t

_
ln(K/S
0
) ( +
1
2

2
)t

t
_
.
A European call option can be priced similarly and has expected future payo
E[max{0, S
t
K}] = S
0
e
()t

_
ln(S
0
/K) + [ +
1
2

2
]t

t
_
K
_
ln(S
0
/K) + (
1
2

2
)t

t
_
.
0.7 Fitting Stock Prices to a Lognormal
Suppose we know n + 1 stock values S
0
, S
t
, S
2t
, . . . , S
nt
where S
it
is the stock price when time is it years. Then we
can t the stock price to a lognormal by nding the parameters m and v as follows:
Since S
it+t
/S
it
are independent and identically distributed, the n values x
i
= ln(S
it+t
/S
it
), 0 i n 1, is a
sample of size n for ln(S
t
/S
0
).
The sample mean is an unbiased estimator of population mean. Hence mt = x =
1
n
(x
1
+x
2
+ +x
n
).
The sample variance is an unbiased estimator of the population variance. Hence v
2
t =
1
n1

n
i=1
(x
i
x)
2
.
0.8 The Black-Scholes Formula
Notations: F
P
(S) = prepaid forward price of asset S, d
1
=
ln(F
P
(S)/F
P
(K)) +
1
2

2
t

t
, and d
2
= d
1

t.
BS Formula: C(S, K, t) = F
P
(S)N(d
1
) F
P
(K)N(d
2
), P(S, K, t) = F
P
(K)N(d
2
) F
P
(S)N(d
1
).
4
Calculating prepaid forward for various assets:
If S is a stock with continuous dividend rate , then F
P
(S) = Se
t
.
If S is a stock with discrete dividends, then F
P
(S) = S PresVal(Dividends).
If S is currency with interest rate r, then F
P
(S) = Se
rt
.
If S is futures and the interest rate is r, then F
P
(S) = Se
rt
.
0.9 The Black-Scholes Formula: Greeks
Let O denote option(call or put) price, S denote asset price,
Delta () is dened as =
O
S
.

Call
= e
t
N(d
1
),
Put
= e
t
N(d
1
),
Call

Put
= e
t
0
Call
1, 1
Put
0.
is an increasing function of asset price.
Gamma () is dened as =

S
=

2
O
S
2
.

Call
=
Put
.
(Deep in the money and out of the money options) 0.
0 and is shaped like a bell curve.
Vega is dened as Vega = 0.01
O

.
Vega(Call) = Vega(Put).
Vega 0.
Higher volatility makes option more valuable.
Theta () is dened as =
1
365
O
t
(measures the change in option price as time advances in days).
Rho () is dened as = 0.01
O
r
.

Call
0,
Put
0, since strikes value depreciates more
is an increasing function of asset price.
Psi () is dened as = 0.01
O

.

Call
0,
Put
0, since asset value depreciates more
is a decreasing function of asset price.
0.10 Elasticity and Sharpe Ratio
= Option elasticity =
Percentage change in option value
Percentage change in asset value
=
/O
/S
=
S
O
.
varies over time.

Call
1,
Put
0.
If the risk free rate is r and an asset has rate of return , then r is called the risk premium.
Instantaneous risk premium of option = (elasticity)(risk premium of asset). i.e. r = ( r).
(follows from: Oe
h
= Se
h
+ (O S)e
rh
e
h
= e
h
+ (1 )e
rh
).
Voaltility of option =|elasticity|(volatility of stock). i.e.
option
= ||
asset
.
5
Sharpe ratio of an asset is dened as
Sharpe ratio =
Risk premium
Volatility
.
Sharpe ratio of option =
r

option
=
( r)
||
asset
=

||
(Sharpe ratio of asset).
Sharpe ratio of a call = sharpe ratio of the asset.
Sharpe ratio of a put = -(sharpe ratio of the asset).
Elasticity of a portfolio =
S
portfolio
O
portfolio
.
0.11 Estimating Volatility
If we assume that volatility of an asset is constant for a given period, then it can be estimated in two ways.
Implied volatility: If we know the value of an option, then we can nd by solving for it in the Black-Scholes
formula. Usually requires numerial methods, but if d
2
= d
1
, then its easy to solve for .
Historical volatility: This is the unbiased standard deviation estimation of ln(S
t
/S
t1
) annualized
0.12 Delta Hedging
A purchased option is the same as buying of the asset and lending some money.
To delta hedge a purchased option, sell of the asset (so that the asset has no eect on the portfolio).
To delta hedge a sold option, buy of the asset.
Market-makers prot from sold options: If the market maker sells an option and delta hedges, then the market
makers prot after t years is
Cost to create portfolio at time 0 =
0
S
0
O
0
.
Income from liquidating portfolio at time t = Sell the
0
assets and buy back the option
=
0
S
t
O
t
.
Prot from portfolio = (Liquidation income) - (Creation cost with interest)
=
0
S
t
O
t
e
rt
(
0
S
0
O
0
).
Market-makers prot from purchased options: If the market maker buys an option and delta hedges, then
the market makers prot after t years is
Cost to create portfolio at time 0 = O
0

0
S
0
.
Income from liquidating portfolio at time t = Sell the
0
assets and buy back the option
= O
t

0
S
t
.
Prot from portfolio = (Liquidation income) - (Creation cost with interest)
= O
t

0
S
t
e
rt
(O
0

0
S
0
).
Market maker makes prot if and only if |S
t
S
0
| S
0

t. Market maker breaks even if and only if S

t
= S
0
S
0

t.
6
0.13 The Delta-Gamma-theta Approximation
By Taylor series, if asset price changes from S
0
to S
t
= S
0
+, then the option price changes from O
0
to
O
t
O
0
+
0
+
0
t +
1
2

2
.
(
0
should be given in years).
0.14 Finding , and from Binomial Tree

0
can be approximated using
0
= e
h
_
O
u
O
d
S
u
S
d
_
.

0
can be approximated using
0


u

d
S
u
S
d
after nding
u
and
d
(requires tree with two or more periods).

0
can be approximated from solving the delta-gamma-theta approximation by looking at ud node: Let = S
ud
S
0
,
then

0

1
2h
_
O
ud
O
0

0

1
2

2
_
.
0.15 Annual variance of return of an Option
The Boyd-Emanuel annual variance of return of an option when rehedging every h in period i is
1
2
(S
2

2
)
2
h.
0.16 Asian Options
An Asian option is an option for which either the strike price or the stock price used in the payo is the average of
the stock prices. The average could be arithmetic average or geometric average.
Asian option comparison:
More frequent average strike option Less frequent average strike option. Thus Asian European.
More frequent average price option Less frequent average price option. Thus Asian European.
(Asian Price Less than European = APPLE).
Geometric price call Arithmetic price call.
Geometric price put Arithmetic price put.
If U =
_
n

i=1
S
ih
_
1/n
is the geometric mean, then we can nd the mean and variance of ln U as follows:
U
n
=
n

i=1
S
ih
=
_
S
0
S
h
S
0
__
S
0
S
h
S
0
S
2h
S
h
__
S
0
S
h
S
0
S
2h
S
h
S
3h
S
2h
_
= S
n
0
n1

i=0
_
S
ih+h
S
ih
_
ni
ln U = ln S
0
+
1
n
n1

i=0
(n i) ln(S
ih+h
/S
ih
).
By Black-Scholes assumption, ln(S
ih+h
/S
ih
) are independent normal variables with mean (
1
2

2
)h and variance

2
h. Thus
E[ln U] = ln S
0
+
1
n
n1

i=0
(n i)(
1
2

2
)h = ln S
0
+
n + 1
2
(
1
2

2
)h
V ar[ln U] =
n1

i=0
(n i)
2
n
2

2
h = (1
2
+ 2
2
+ +n
2
)

2
h
n
2
.
7
0.17 Barrier Options
Knock-out options: Option doesnt pay if the asset reaches the barrier price over the lifetime of the option.
up-and-out: If the asset price rises to the barrier, then the option does not pay.
down-and-out: If the asset price falls to the barrier, then the option does not pay.
Knock-in options: Option pays only if the asset reaches the barrier price over the lifetime of the option.
up-and-in: The option pays only if the asset price rises to the barrier.
down-and-in: The option pays only if the asset price falls to the barrier.
Rebate options A xed payment if the asset reaches the barrier price over the lifetime of the option.
up rebate: The option pays a xed amount only if the asset price rises to the barrier.
down rebate: The option pays a xed amount only if the asset price falls to the barrier.
Combining barrier options with same barrier can result in ordinary options:
Up-and-in + Up-and-out = Ordinary option = Down-and-in + Down-and-out.
The following identities are useful in pricing contingent claims(claims which depend on the value of an asset):
max(0, S K) = Call, max(0, K S) = Put,
max(S, K) = S +Put = K +Call, min(S, K) = K Put = S Call.
0.18 Compound Options
An option on an option is called a compound option. The underlying option must have a longer life.
PutOnCall allows you to sell a call, CallOnCall allows you to buy a call, and so on...
Let x, t
1
denote the strike price and time to expiry of the compound option respectively. Then
CallOnCall PutOnCall = Call xe
rt1
, CallOnPut PutOnPut = Put xe
rt1
.
0.19 Pricing american options with one discrete dividend
The only time it is rational to exercise an American call option before expiry with one discrete dividend is right
before the stock pays the dividend.
If the stock has exactly one discrete dividend D at time t
1
, then
C
Amer
(S, K, T) = S
0
Ke
rt1
+ CallOnPut
_
S, K, D K(1 e
r(Tt1)
), t
1
, T
_
.
0.20 All-or-nothing Options
Asset-or-nothing call options: (S|S > K). Pays S if S > K and nothing otherwise. O(S|S > K) = S
0
e
T
N(d
1
).
Asset-or-nothing put options: (S|S < K). Pays S if S < K and nothing otherwise. O(S|S < K) = S
0
e
T
N(d
1
).
Cash-or-nothing call options: (1|S > K). Pays 1 if S > K and nothing otherwise. O(1|S > K) = e
rT
N(d
2
).
Cash-or-nothing put options: (1|S < K). Pays 1 if S < K and nothing otherwise. O(1|S < K) = e
rT
N(d
2
).
Call = (S|S > K) (K|S > K), Put = (K|S < K) (S|S < K).
Find for all-or-nothing options by dierentiation.
8
0.21 Gap Options
There is a trigger price K
2
and a strike price K
1
. A gap option is one where K
1
= K
2
.
For a gap option, election is not optional. If the trigger is met then the purchaser must exercise the option.
Gap options can have negative payos and premiums.
To price a gap option, calculate d
1
using trigger price and premium using strike price.
GapCall = (S|S > K
2
) (K
1
|S > K
2
), GapPut = (K
1
|S < K
2
) (S|S < K
2
).
Find for gap options by dierentiation.
0.22 Exchange Options
Let S be the asset which is to be recieved in exchange of the asset Q.
The option price is O = F
P
(S)N(d
1
) F
P
(Q)N(d
2
) where now depends on both the assets and is found using

2
= V ar[ln S ln Q] = V ar[ln S] +V ar[ln Q] 2Cov[ln S, ln Q] =
2
S
+
2
Q
2
S

Q
where is the correlation coecient of the two assets.
0.23 Chooser Options
A chooser-option/as-you-like-it option allows one to choose, at time t T, to take either a call or a put option
expiring at time T.
We can price a chooser option by looking at its value at time t:
O
t
= max{C(S, K, t, T), P(S, K, t, T)}
= C(S, K, t, T) + max{0, P(S, K, t, T) C(S, K, t, T)}
= C(S, K, t, T) + max{0, Ke
r(Tt)
Se
(Tt)
}
= C(S, K, t, T) +e
(Tt)
max{0, Ke
(r)(Tt)
S}
O = C(S, K, 0, T) +e
(Tt)
P(S, Ke
(r)(Tt)
, 0, T).
O
t
= max{C(S, K, t, T), P(S, K, t, T)}
= P(S, K, t, T) + max{0, C(S, K, t, T) P(S, K, t, T)}
= C(S, K, t, T) + max{0, Se
(Tt)
Ke
r(Tt)
}
= C(S, K, t, T) +e
(Tt)
max{0, S Ke
(r)(Tt)
}
O = P(S, K, 0, T) +e
(Tt)
C(S, Ke
(r)(Tt)
, 0, T).
0.24 Forward Start Options
A Forward start option is a prepaid forward on an option which will start at time t > 0 and expire at time T > t.
We can price a forward start option if the strike price K is a multiple of the asset price at time t say K = cS
t
. For
in this case we can calculate d
1
and d
2
without knowing the value of S
t
: d
1
=
ln c + (r +
1
2

2
)(T t)

T t
and
C
t
= S
t
e
(Tt)
N(d
1
) cS
t
e
r(Tt)
N(d
2
), P
t
= cS
t
e
r(Tt)
N(d
2
) S
t
e
(Tt)
N(d
1
).
C = F
P
0,t
(S)
_
e
(Tt)
N(d
1
) ce
r(Tt)
N(d
2
)
_
, P = F
P
0,t
(S)
_
ce
r(Tt)
N(d
2
) S
t
e
(Tt)
N(d
1
)
_
.
9
0.25 Generating Lognormal Random Numbers and Simulating Stock Prices
There are two methods suggested to generate a standard normal number from uniform random numbers in (0,1].
Inversion method: u
i
N
1
(u
i
) or
From twelve uniform (0,1] numbers we generate one standard normal number: {u
i
}
12
i=1

12

i=1
u
i
6.
Given a standard normal number z
i
, we can generate a lognormal number with parameters m, v: z
i
e
m+vzi
.
Given a standard normal number z
i
, we can generate a stock price S
t
of a stock with given , , :
m = (
1
2

2
)t, v =

t, S
t
= e
m+vzi
.
Given a list of n standard normal numbers, we can use them to
Generate one value of S
t
by generating n values of S
t
and averaging them.
Generate a path of values of the asset where each normal number is used to predict the next stock value.
While pricing options:
If discounting is needed, then use risk-neutral distribution (use r instead of ).
If discounting is not needed, then use true distribution. In otherwords, use .
0.26 Control Variate Method
Suppose we want to simulate X and if there is a Y which is highly correlated to X and has a closed form formula E[Y ],
then we can improve the simulated value of X by using X

=

X + (E[Y ]

Y ). This estimation has less variance than
the estimation

X. This method is called the control variate method and Y is called a control variate of X.
0.27 Boyle Modication
To estimate X, which is highly correlated to Y , we can use the formula
X

=

X +(E[Y ]

Y ), where =
Cov(X, Y )
V ar(Y )
=

XY

Y
.
This has variance Var[X

] =
2
X
(1
2
XY
) which is the lowest variance possible with control variate method.
0.28 Antithetic Variate Method
In this method, for each uniform number u
i
generated from (0,1], we also use the number 1 u
i
. Thus for n generated
numbers we will be having 2n values.
0.29 Stratied Sampling
Consider a partition of the interval (0,1] into n equally lengthed intervals. Each part is called a strata. For k uniform
numbers in (0,1], we generate nk uniform numbers, by mapping them into each strata.
10
0.30 Brownian Motion
Some properties of a random walk are:
A random walk has no memory: Pr[X(t +u) = l | X(t) = k] = Pr[X(u) = l k].
Distance traversed is not random. Sum of the squares of the movements is 1.

1
2
(X(t) +t) is a binomial distribution with parameters t and
1
2
.
If we took a random walk which moved

h per h units of time and took the limit as h 0, we will get a

continuous random walk. The binomial distribution would then converge to a normal random variable. This is
called a Browninan motion.
Every Brownian motion Z(t) satisfy the following properties:
Z(0) = 0.
Z(t) is continuous in t.
Z(t +s) Z(t) is N(0, s) (i.e. Z(t +s) Z(t) is normal with mean 0 and variance s).
Z(t +s
1
) Z(t) is independent of Z(t) Z(t s
2
) (nonoverlapping increments are independent).
0.31 Arithmetic Brownian Motion
An arithmetic Brownian motion has the form X(t) = X(0) + mt + vZ(t) where Z(t) is a Brownian motion. Also
written as dX(t) = mdt +vdZ(t) where dZ(t) is N(0, dt). Thus dX(t) is N(mdt, v
2
dt).
m is called the drift and v is called the volatility of the process.
X(t +s) X(t) = N(ms, v
2
s).
Cov(X(t), X(u)) =
2
min{t, u}.
0.32 Geometric Brownian Motion
X(t) is said to be a geometric Brownian motion if ln X(t) is an arithmetic Brownian motion.
If ln X(t) = ln X(0) +mt +vZ(t), then
ln(X(t)/X(0)) is N(mt, v
2
t)
E[X(t)] = X(0)e
mt+
1
2
v
2
t
.

dX(t)
X(t)
= adt +bdZ(t) ln(X(t)/X(0)) is N((a
1
2
b
2
)t, b
2
t).
d(ln X(t)) = adt +bdZ(t) ln(X(t)/X(0)) is N(at, b
2
t).
If a stock price S
t
is modeled on geometric brownian motion (with , , , denoting the usual), then v = and
E[S
t
] = S
0
e
()t
= S
0
e
(m+
1
2
v
2
)t
m =
1
2
v
2
.
Thus ln(S
t
/S
0
) is N((
1
2

2
)t,
2
t).
Cov(X(t), X(u)) = X(0)
2
e
(m+
1
2
v
2
)(t+u)
(e
v
2
min{t,u}
1).
Var[ln S(t)|S(0)] =
2
t implies volatility of the stock is .
Var[ln S(t)|S(0)] = Var[ln F
0,t
(S)] = Var[ln F
P
0,t
(S)].
11
0.33 It os Lemma
A random process X(t) satisfying dX(t) = (t, X)dt +(t, X)dZ(t) is called an Ito process
Itos Lemma: If S is an Ito process dS = dt +dZ and O is a function of S and t, then
dO = O
S
dS +O
t
dt +
1
2
O
SS
(dS)
2
= O
S
dS +O
t
dt +
1
2
O
SS

2
dt.
While using Itos Lemma, treat Z(t) and t as independent variables.
0.34 Black-Scholes Equation
Suppose we have an option O on an asset S. Let V be the value of the delta hedged portfolio for the option O.
dV = dO O
S
(dS +Sdt) (O O
S
S)rdt = 0 (Since the portfolio is delta-hedged, this must equal 0).
If dS = ( )Sdt +SdZ, then (dS)
2
=
2
S
2
dt and
dO = O
S
dS +O
t
dt +
1
2
O
SS
(dS)
2
= O
S
dS +O
t
dt +
1
2
O
SS

2
S
2
dt.
Thus
0 = O
S
dS +O
t
dt +
1
2
O
SS

2
S
2
dt O
S
(dS +Sdt) (O O
S
S)rdt.
O
t
+
1
2
O
SS

2
S
2
+ (r )O
S
S = rO.
rO = +
1
2

2
S
2
+ (r )S.
This is called the Black-Scholes equation.
0.35 Sharpe Ratio of Assets following Same It o Process
Assets following Ito processes with same Z must have same Sharpe Ratio.
0.36 Risk-Neutral Processes
If the true process is dS = ( )Sdt +SdZ, then it can be translated into the risk-neutral process:
dS = ( )Sdt +SdZ
= (r )Sdt + ( r)Sdt +SdZ
= (r )Sdt +S
_
r

dt +dZ
_
= (r )Sdt +Sd

Z
where d

Z = dt +dZ, and =
r

is the Sharpe Ratio.

12
0.37 Proportional Portfolio
If portion of a protfolio W consists of a risky asset S with given , and and rest 1 portion is a risk free
asset, then the process followed by W is dW = ( + (1 )r
W
)Wdt +WdZ where
W
is the dividend rate
of the portfolio (and not the asset S).
0.38 S
a
Let S be an asset with given , and , then
S(T) = S(0)e
(
1
2

2
)T+Z(T)
S(T)
a
= S(0)
a
e
(
1
2

2
)aT+aZ(T)
E[S(T)
a
] = S(0)
a
e
(
1
2

2
)aT+
1
2

2
a
2
T
.
In a risk-neutral world this becomes
E[S(T)
a
] = S(0)
a
e
(r
1
2

2
)aT+
1
2

2
a
2
T
.
Hence
F
P
0,T
(S
a
) = e
rT
S(0)
a
e
(r
1
2

2
)aT+
1
2

2
a
2
T
The Ito process followed by O = S
a
is
dO
O
=
_
a( ) +
1
2
a(a 1)
2
_
dt +adZ.
The volatility of S
a
is a.
The rate of return of S
a
is = a( r) +r.
0.39 Stochastic Integration

_
dZ
2
=
_
dt = t.

_
2ZdZ = Z
2
t.
d
__
t
0
X(s)dZ(s)
_
= X(t)dZ(t).
0.40 Interest Rate Binomial Tree
Convention: time t = n means the end of nth year.
Let P(T, T + s) denote the time T cost to buy a zero-coupon bond for 1 issued at time T and maturing at time
T +s. This is called the T-year forward price of an s-year bond.
P(0, s) is called a spot rate.
t
1
t
2
t
2
P(t
2
, t
2
)P(t
2
, t
3
) = P(t
1
, t
3
).
13
0.41 Black-Derman-Toy Binomial Tree
The interest rates used in BDT tree are eective annual rates.
R
h
denotes the eective annual interest rate for the current time at the lowest node.

h
denote the lognormal yield volatility for one-year bonds issued at the beginning of a period.
A BDT tree is a binomial tree of 1-year interest rates such that if r
u
and r
d
are two consecutive possible rates in
the tree for i-th year, then 2
i

h = ln(r
u
/r
d
)
0.42 Caps and Caplets
A cap gaurantees that the borrower will not have to pay more than a xed interest rate regardless of what the
oating rate is.
If K
R
is the cap rate and R
T
is the interest rate for year T, then the cap pays max (0, R
T
K
R
) at the end of year
T.
A caplet is a cap which is only for a particlar year. Thus a cap for n years is a collection of n caplets.
Pricing caps:
0.43 The Black Formula for Bond Options
The cost of a call option allowing purchase of a bond at time T which matures to 1 at time T +s is calculated using
F
P
0,T
(S) = P(0, T +s) and F
P
0,T
(K) = P(0, T)K in the black scholes formula (where K is the strike price).
0.44 Pricing Caplets and Floorlets
A caplet with strike rate K
R
can be priced by rewriting it as a put: A caplet for year T pays max{0,
R
T
K
R
1+R
T
} and
max
_
0,
R
T
K
R
1 +R
T
_
= (1 +K
R
) max
_
0,
1
1 +K
R

1
1 +R
T
_
.
Thus the caplet is worth (1 +K
R
) times a put.
A oorlet can be priced similarly
0.45 Interest Rate Models
We use continuously compounded interest rates.
An arbitrarily specied set of bond prices may allow arbitrage. All zero-coupon bonds can not have the same yield
to maturity.
Let P(t, T, r) be the price of a zero coupon bond purchased at time t and maturing at time T when the short term
rate is r.
Let R(t, T) be the yield on the zero coupon bond with price P(t, T, r). Then R(t, T) =
ln(P(t,T,r))
Tt
.
The short rate r(t) is dened as r(t) = lim
Tt
R(t, T).
14
The short rate is assumed to follow an Ito process dr(t) = a(r)dt +(r)dZ(t).
We can nd dP using Itos Lemma:
dP = P
r
dr +P
t
dt +
1
2
P
rr
(dr)
2
=
_
aP
r
+
1
2

2
P
rr
+P
t
_
dt +P
r
dZ = Pdt qPdZ
where =
1
P
(aP
r
+
1
2

2
P
rr
+P
t
) and q =
1
P
P
r
.
Corresponding Sharpe Ratio is (r, t) =
(r, t, T) r
q(r, t, T)
.
Sharpe ratios for bond prices have same sign. (so we keep them positive).
Sharpe ratio can not vary with T otherwise there will be arbitrage opportunity.
The risk premium of a bond P(t, T, r) is dened as (r, t)(r) =
aPr+
1
2

2
Prr+PtrP
Pr
. Rewriting this gives the
analog of Black-Scholes equation for bond prices: rP = (a +)P
r
+
1
2

2
P
rr
+P
t
.
The corresponding risk-neutral process is found using d

Z = dZ dt.
The Rendleman-Bartter Model for interest rates is: dr = ardt +rdZ (i.e. geometric Brownian motion) where
a and are independent of r.
0.46 Vasicek Model
The Vasicek Model is dr = (b r)adt +dZ. The Sharpe ratio does not vary with r or t.
Given parameters a = 0, b, and , we can solve the dierential equation rP = ((b r)a +)P
r
+
1
2

2
P
rr
+P
t
to
get
r = b+

a


2
2a
2
, B(t, T) =
1
a
(1e
a(Tt)
), A(t, T) = e
r[B(t,T)(Tt)]
B(t,T)
2

2
4a
, P(t, T, r) = A(t, T)e
B(t,T)r(t)
.
r is the yield to maturity on an innitely lived bond.
If a = 0, then the solution is B(t, T) = T t, A(t, T) = e

2
(Tt)
2
+

2
6
(Tt)
3
, P(t, T, r) = A(t, T)e
B(t,T)r(t)
.
and are: = P
r
= B(t, T)P(t, T, r), = P
rr
= B(t, T)
2
P(t, T, r).
0.47 The Cox-Ingersoll-Ross Model
The Cox-Ingersoll-Ross Model is : dr = a(b r)dt +

rdZ.
The Cox-Ingersoll-Ross Model is specied using four parameters: a, b, and

where (r, t) =

r

is the Sharpe-
ratio.
The yield to maturity on an innitely lived bond is r =
2ab
a +
_
(a )
2
+ 2
2
.
15