Formulas for Finance

Joao Pedro Pereira

Finance Department
ISCTE Business School - Lisbon
joao.pereira@iscte.pt
www.iscte.pt/jpsp
May 18, 2009
Contents
1 Basic Functions 2
1.1 Logarithm . . . . . . . . . . . . . . . . . . . . 2
2 Probability 2
2.1 Combinatorics . . . . . . . . . . . . . . . . . 2
2.2 Moments . . . . . . . . . . . . . . . . . . . . 2
2.2.1 Mean and Variance . . . . . . . . . . . 2
2.2.2 Skewness and Kurtosis . . . . . . . . . 2
2.2.3 Conditional . . . . . . . . . . . . . . . 2
2.2.4 Covariance . . . . . . . . . . . . . . . 2
2.2.5 Multivariate distributions . . . . . . . 3
2.2.6 Linear combinations . . . . . . . . . . 3
2.3 Independence . . . . . . . . . . . . . . . . . . 3
2.4 Distributions . . . . . . . . . . . . . . . . . . 3
2.4.1 S
n
Binomial(n,p) . . . . . . . . . . 3
2.4.2 X Poisson() . . . . . . . . . . . . . 3
2.4.3 X Exponential() . . . . . . . . . . 3
2.4.4 X Normal(m, s
2
) . . . . . . . . . . . 3
2.4.5 (X, Y ) Bivariate Normal . . . . . . 3
2.4.6 Y Lognormal . . . . . . . . . . . . 4
2.5 Stochastic Processes . . . . . . . . . . . . . . 4
2.5.1 Random walk . . . . . . . . . . . . . . 4
2.5.2 Poisson . . . . . . . . . . . . . . . . . 4
3 Statistics and Econometrics 4
3.1 Linear Regression . . . . . . . . . . . . . . . . 4
3.1.1 OLS . . . . . . . . . . . . . . . . . . . 4
3.2 Time Series . . . . . . . . . . . . . . . . . . . 4
3.2.1 Lag operator . . . . . . . . . . . . . . 4
3.2.2 Stationarity . . . . . . . . . . . . . . . 5
3.2.3 Typical stationary processes . . . . . . 5
3.2.4 Typical nonstationary processes . . . . 5

The necessary condition for a formula to be here is that

someone has used it to solve a problem related to Finance.
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4 Linear Algebra 5
4.1 Transpose . . . . . . . . . . . . . . . . . . . . 5
4.2 Product . . . . . . . . . . . . . . . . . . . . . 5
4.3 Trace . . . . . . . . . . . . . . . . . . . . . . . 5
4.4 Rank . . . . . . . . . . . . . . . . . . . . . . . 5
4.5 Determinant . . . . . . . . . . . . . . . . . . . 6
4.6 Inverse . . . . . . . . . . . . . . . . . . . . . . 6
4.7 Generalized inverse . . . . . . . . . . . . . . . 6
4.8 Quadratic Forms . . . . . . . . . . . . . . . . 6
4.9 Kronecker (tensor) product. . . . . . . . . . . 6
4.10 Orthogonality . . . . . . . . . . . . . . . . . . 6
4.11 Vector Spaces . . . . . . . . . . . . . . . . . . 7
5 Calculus and Analysis 7
5.1 Basic rules of derivatives . . . . . . . . . . . . 7
5.2 Implicit function theorem . . . . . . . . . . . 7
5.3 Matrix calculus . . . . . . . . . . . . . . . . . 7
5.3.1 Scalar-valued functions . . . . . . . . 7
5.3.2 Some rules . . . . . . . . . . . . . . . 7
5.4 Concave function . . . . . . . . . . . . . . . . 8
5.5 Integrals . . . . . . . . . . . . . . . . . . . . . 8
6 Stochastic Calculus 8
6.1 Standard Brownian motion or standard
Wiener Process . . . . . . . . . . . . . . . . . 8
6.1.1 Denition ... . . . . . . . . . . . . . . 8
6.1.2 Multiplication rules . . . . . . . . . . 8
6.2 Itos Lemma . . . . . . . . . . . . . . . . . . . 8
7 Optimization 8
7.1 Unconstrained optimization . . . . . . . . . . 8
7.2 Equality constraints . . . . . . . . . . . . . . 9
8 Finance 9
8.1 Utility . . . . . . . . . . . . . . . . . . . . . . 9
8.2 Stochastic Dominance . . . . . . . . . . . . . 9
8.3 Mean-Variance Frontiers . . . . . . . . . . . . 9
8.3.1 Only risky assets . . . . . . . . . . . . 9
8.3.2 With a risk-free asset . . . . . . . . . 10
8.4 CAPM . . . . . . . . . . . . . . . . . . . . . . 10
8.5 APT . . . . . . . . . . . . . . . . . . . . . . . 10
8.6 Fama-French . . . . . . . . . . . . . . . . . . 10
8.7 Performance measures . . . . . . . . . . . . . 10
8.8 Arrow-Debreu pricing . . . . . . . . . . . . . 10
1
8.9 Risk-Neutral Pricing . . . . . . . . . . . . . . 10
8.10 Consumption Asset Pricing . . . . . . . . . . 11
8.10.1 Fundamental equation . . . . . . . . . 11
8.10.2 Relation to AD prices . . . . . . . . . 11
8.10.3 Relation to RN probabilities . . . . . 11
8.10.4 Risk Premiums . . . . . . . . . . . . . 11
8.10.5 Relation to the CAPM . . . . . . . . . 11
8.10.6 Consumption CAPM (CCAPM) . . . 11
8.11 Black-Scholes . . . . . . . . . . . . . . . . . . 11
8.11.1 Greeks . . . . . . . . . . . . . . . . . . 11
8.12 Value-at-Risk . . . . . . . . . . . . . . . . . . 11
9 L
A
T
E
Xtricks 12
1 Basic Functions
1.1 Logarithm
Denition. log
a
x = y a
y
= x
Some properties:
log(xy) = log x + log y
log(x/y) = log x log y
log(x
p
) = p log x
log(1 +)

= , for small
2 Probability
Let F
X
(.) and f
X
(.) denote respectively the cumu-
lative distribution function and the probability den-
sity function of the random variable X. g(X) and
h(X) are real functions of the random variable X.
2.1 Combinatorics
Possible combinations (subsets) of n objects taken
r at time is:
_
n
r
_
=
n!
r!(n r)!
for r = 0, 1, . . . , n
Binomial theorem. (x+y)
n
=

n
r=0
_
n
r
_
x
nr
y
r
for any positive integer n.
2.2 Moments
Denition (Moments). The moments about the
origin of a random variable X are

X
r
E[X
r
]
_
x
r
dF
X
(x) =
_
x
r
f
X
(x) dx
for r = 0, 1, 2, . . . . The moments about the mean,
or centered moments, are

r
E[(X E[X])
r
]
2.2.1 Mean and Variance
Denition (Mean or Expected Value). E[X]

X
1


X. For a function g, E[g(X)] =
_
g(x)f
X
(x) dx.
Some properties (lowercase are constants):
E[a +bX] = a +bE[X]
E[g(X) +h(X)] = E[g(X)] +E[h(X)]
Jensens inequality E[g(X)] g(E[X]), for
concave g. If g is strictly concave, the inequality
is strict.
Denition (Variance). Var[X]
2
= E[(X

X)
2
] = E[X
2
]

X
2
Some properties (lowercase are constants):
Var[a +bX] = b
2
Var[X]
Var[a +bX +cY ] = b
2
Var[X] +c
2
Var[Y ]+
+2bc Cov(X, Y )
2.2.2 Skewness and Kurtosis
Denition (Skewness). The skewness is
3
/
3

E[(X

X)
3
]/
3
. Its zero for symmetrical distri-
butions. Positive means long tail to the right.
Denition (Kurtosis). The kurtosis is
4
/
4

E[(X

X)
4
]/
4
. Its 3 for the normal distribution.
Values higher than 3 mean thick tails (relative to
the normal). Sometimes presented as excess kurt
= kurtosis - 3.
2.2.3 Conditional
Iterated expectations. E[E[x|I
1
]|I
0
] =
E[x|I
0
], for I
0
I
1
. In a time series notation,
E
t
[E
t+1
[x
t+2
]] = E
t
[x
t+2
].
2.2.4 Covariance
Cov(X, Y ) E[(X EX)(Y EY )]
= E[XY ] E[X]E[Y ]
2
Some properties (lowercase are constants):
Cov(a +X, Y ) = Cov(X, Y )
Cov(aX, bY ) = ab Cov(X, Y )
Cov(aX, bY +cZ) = Cov(aX, bY ) + Cov(aX, cZ)
Cov(aX +bY, cX +dY ) = ac Var(X)+
+bd Var(Y ) + (ad +bc) Cov(X, Y )
The correlation coecient is
(X, Y ) :=
Cov(X, Y )
_
Var(X) Var(Y )
Thus,
XY
=
X

Y
. Always have 1 +1.
X and Y are linearly dependent (Y = aX+b, a, b
R) i = 1.
2.2.5 Multivariate distributions
Let x be a (column) random vector.
E[x] =
_

_
E[x
1
]
.
.
.
E[x
n
]
_

_
Cov[x] =
_

_
.
.
.
. . .
ij
. . .
.
.
.
_

_
= E[(x E[x])(x E[x])

]
= E[xx

] E[x]E[x]

Cov[x] is positive semi-denite.

2.2.6 Linear combinations
Let x be a (column) random vector. Let a and b
be vectors of constants. Then,
E[a

x] = a

E[x]
Var[a

x] = a

Cov[x] a
Cov(a

x, b

x) = a

Cov[x] b
2.3 Independence
Two random variables X and Y are independent if
for any two sets A and B,
P(X A, Y B) = P(X A)P(Y B)
Theorem If X and Y are independent, then
E[g(X)h(Y )] = E[g(X)]E[h(Y )] for any functions
g(X) and h(Y ).
2.4 Distributions
2.4.1 S
n
Binomial(n,p)
P(S
n
= k) =
_
n
k
_
p
k
(1 p)
nk
for k = 0, . . . , n
Use: S
n
is the number of successes in n experi-
ments when the probability of success in each trial
is p.
2.4.2 X Poisson()
P(X = k) = e

k
/k! for k = 0, 1, 2, . . .
E[X] = V ar[X] =
If X Poisson() and Y Poisson() are in-
dependent, then X +Y Poisson( +).
2.4.3 X Exponential()
f(x) =
_
0 , x < 0
e
x
, x 0
F(x) =
_
0 , x < 0
1 e
x
, x 0
Use: waiting time between events.
E[X] = 1/ and V ar[X] = 1/
2
2.4.4 X Normal(m, s
2
)
f(x) =
1

2s
2
exp
_

1
2
_
x m
s
_
2
_
Moment generating function. For R,
E
_
e
X

= exp
_
m+
1
2

2
s
2
_
Properties: If X (m, s
2
), then (a + bX)
(a +bm, b
2
s
2
)
2.4.5 (X, Y ) Bivariate Normal
The bivariate normal with parameters
(m
x
, m
y
, s
2
x
, s
2
y
, ) is
f(x, y) =
1
2s
x
s
y
_
1
2
exp
_
z
2
x
+z
2
y
2z
x
z
y
2(1
2
)
_
with z
i
= (i m
i
)/s
i
, i = x, y.
3
2.4.6 Y Lognormal
Y is lognormally distributed if lnY = X
N(m, s
2
).
f(y) =
_
_
_
0 , y 0
1
y

2s
2
exp
_

1
2
_
ln ym
s
_
2
_
, y > 0
Moments:
E[Y ] = E[e
X
] = e
(m+
1
2
s
2
)
V ar[Y ] = E[e
2X
] E[e
X
]
2
= e
2m+s
2
_
e
s
2
1
_
2.5 Stochastic Processes
2.5.1 Random walk
S
t
= S
t1
+ +
t
,
t
iid (0, 1) (1)
Remark. If = 0, the process is called random walk
with drift .
Remark. If
t
iidN (0, 1), then S
t
< 0 with non-
zero probability. For security prices, it is more com-
mon to assume the random walk for log prices:
ln(S
t
) = ln(S
t1
) + +
t
S
t
= S
t1
exp( +
t
)
which ensures prices will remain positive. Note that
S
t
is lognormal.
2.5.2 Poisson
{N(t), t 0} is a Poisson process with rate i:
(i) N(0) = 0; (ii) N(t +h) N(t) Poisson(h);
(iii) N(t) has independent increments.
Use: N(t) is the number of arrivals by time t.
Remark. N(t) has a Poisson distribution with mean
t.
Remark. interarrival times are distributed
exponential().
Remark. P[N(t + h) N(t) = 1] = h + o(h),
i.e. probability of one more arrival is proportional
to length of interval (for small interval h). Also,
P[N(t +h) N(t) 2] = o(h).
Theorem 2.1. If a counting process starts at zero,
has independent increments, and satises P[N(t +
h)N(t) = 1] = h+o(h) and P[N(t+h)N(t)
2] = o(h), then it is a Poisson process with rate .
Remark. In the continuous time limit, and allow-
ing for a (deterministic) time-varying intensity, the
probability of m jumps is
P[N(s) N(t) = m] =
1
m!
__
s
t
(u)du
_
m
exp
_

_
s
t
(u)du
_
In particular, the survival probability in some
credit models is
P[N(s) N(t) = 0] = exp
_

_
s
t
(u)du
_
3 Statistics and Econometrics
3.1 Linear Regression
3.1.1 OLS
Model: y = X + , with T observations and K
regressors. The normal equations are X

e = 0. The
estimates are:
b = (X

X)
1
X

y
V ar(b|X) =
2
(X

X)
1
,
2
= e

e/(T K)
3.2 Time Series
3.2.1 Lag operator
Denitions:
Ly
t
y
t1
L
k
y
t
y
tk
(L)
0
+
1
L +
2
L
2
+. . .
Remark. Usually,
0
= 1, and write (L)y
t
= 1 +

1
y
t1
+
2
y
t2
+. . .
Remark. (1cL)
1
= lim
j
(1+cL+c
2
L
2
+ +
c
j
L
j
) with the property (1 cL)
1
(1 cL) = 1
First dierence operator is related to L by
y
t
y
t
y
t1
= (1 L)y
t
For example,
2
y
t
= (1L)
2
y
t
= (12L+L
2
)y
t
=
y
t
2y
t1
+y
t2
.
4
3.2.2 Stationarity
Denition (Covariance or Weak Stationarity). Nei-
ther the mean nor the autocovariances depend on
the date t:
E[y
t
] = , t
E[(y
t
)(y
tk
)] =
k
, t, k
Rule of thumb: the autocorrelation function
(ACF,
k
=
k
/
0
) of a stationary process either
abruptly drops to 0 at some k (signalling an MA(k-
1)) or eventually decreases to 0.
3.2.3 Typical stationary processes
White Noise is a sequence {}
+
t=
satisfying
E
t
= 0, E
2
t
=
2
, and E[
t

s
] = 0, t = s. An
independent white noise further requires
t
and

s
to be independent for t = s and is denoted

t
iid(0,
2
). With further normality, we get a
Gaussian white noise,
t
iidN(0,
2
).
AR(1) First-order autoregressive process:
y
t
= c +y
t1
+
t
where
t
is white noise. The stationarity condition
is || < 1. Some properties:
E[y
t
] = c/(1 )
Var[y
t
] =
2
/(1
2
)
Cov[y
t
, y
tj
] =
j
Var[y
t
]

j
=
j
3.2.4 Typical nonstationary processes
Deterministic time trend
y
t
= c
0
+c
1
t +(L)
t
Also called trend-stationary (because y
t
c
1
t is sta-
tionary).
Unit root
y
t
= c +y
t1
+(L)
t
Also called dierence-stationary (because (1L)y
t
is stationary). Also called integrated of order 1,
y
t
I(1). The typical example is the random walk
(1) (note that shocks have permanent eects).
Remark. The random walk with drift also has a
time trend: y
t
= c +y
t1
+
t
= y
0
+ct +

t
s=1

s
.
4 Linear Algebra
Note: capital letters are matrices; lowercase are col-
umn vectors; Greeks are scalars.
4.1 Transpose
Properties:
A is symmetric i A = A

(A

= A
(A+B)

= A

+B

4.2 Product
x

y = y

x
(AB)C = A(BC)
A(B +C) = AB +AC
(ABC)

= C

4.3 Trace
The trace of a square matrix is the sum of its diag-
onal elements.
tr(I
n
) = n
tr(A) = tr(A)
tr(A

) = tr(A)
tr(A+B) = tr(A) +tr(B)
tr(ABC) = tr(CAB) = tr(BCA)
x

y = tr(x

y) = tr(y

x) = tr(xy

) = tr(yx

)
4.4 Rank
The column rank is the number of independent
columns. The row rank is the number of indepen-
dent rows.
Theorem 4.1. Column rank = Row rank. Hence,
we can speak of just rank.
Denition (full rank). A matrix has full column
rank if its rank is equal to the number of columns
(similarly for full row rank). The term full rank
usually means full column rank.
Properties:
rank(A) = rank(A) = rank(AA) = rank(AA)
5
4.5 Determinant
For a 2x2 matrix, the determinant is

a b
c d

= ad cb
In general, the determinant of a square matrix A
of size K is:
|A| =
K

k=1
a
ik
(1)
i+k
|A
ik
|, for any row i
where a
ik
is the ik-th element of A and A
ik
is
whats left of A after deleting the row and column
that go through a
ik
. |A| can also be computed
along any column instead; pick the row or col with
most zeroes.
Remark. The determinant is only dened for square
matrices
Proposition 4.1. |A| = 0 i A has full rank.
Properties:
If D is diagonal, then |D| = d
1
d
2
. . . d
K
.
4.6 Inverse
Denition. The inverse of a square matrix is such
that AA
1
= A
1
A = I. A is nonsingular i A
1
exists.
|A
1
| = 1/|A|
(A
1
)
1
= A
(A
1
)

= (A

)
1
(AB)
1
= B
1
A
1
If A is symmetric, then A
1
is symmetric.
A is singular i |A| = 0.
If D is diagonal, then
D
1
=
_

_
1/d
11
0 . . . 0
0 1/d
22
. . . 0
.
.
.
.
.
.
.
.
.
.
.
.
0 0 . . . 1/d
nn
_

_
4.7 Generalized inverse
For any A (even singular or not square), there is
a unique A

, called the Moore-Penrose inverse or

pseudoinverse of A, satisfying:
1) AA

A = A
2) A

AA

= A

3) A

A is symmetric
4) AA

is symmetric
4.8 Quadratic Forms
Denition. A quadratic form in a symmetric ma-
trix A is the scalar x

Ax.
Denition (Deniteness). For given symmetric A,
1. If x

Ax > 0 () for all nonzero x, then A is

positive (semi)denite.
2. If x

Ax < 0 () for all nonzero x, then A is

negative (semi)denite.
Properties:
If A is PSD, then |A| 0.
If A is PD, then A
1
is also PD.
4.9 Kronecker (tensor) product.
A
..
m.n
B
..
o.p
= X
..
mo.np
=
_

_
a
11
B a
12
B
a
21
B
.
.
.
.
.
.
.
.
.
_

_
Note: AB = B A
Rules:
(AB)
1
= (A
1
B
1
)
(AB)(C D) = AC BD
For square A
(m.m)
and B
(p.p)
:
(AB)

= A

4.10 Orthogonality
Two nonzero vectors are orthogonal (x y), or
perpendicular, i x

y = y

x = 0.
6
4.11 Vector Spaces
Linear dependence A set of vectors is linear
dependent if any one of the vectors can be written
as a linear combination of the others.
Linear independence A set of vectors is linear
independent i the only solution to
1
x
1
+ +

n
x
n
= 0 is
1
= =
n
= 0
5 Calculus and Analysis
5.1 Basic rules of derivatives
Let f and g be functions of x. Let

f be the inverse
function of f, i.e.,

f(f(x)) = x. Let a be a constant.
Function Derivative
af af

fg f

g +fg

f/g (f

g fg

)/g
2
f
a
af

f
a1
e
f
f

e
f
a
g
g

a
g
lna
f
g
gf

f
g1
+g

f
g
lnf
lnx 1/x
lnf f

/f
inv.fn

f 1/f

LHopitals rule. For a [, +],

lim
xa
f(x)
g(x)
= lim
xa
f

(x)
g

(x)
Taylor rule. If f is innitely dierentiable
around the point x = a, then
f(x) = f(a) +f

(a)(x a) +
1
2
f

(a)(x a)
2
+
+
1
n!
f
(n)
(a)(x a)
n
+. . .
Note: this representation is not always valid; weird
examples exist where the series does not converge
to f.
Chain rule.
df(g(x))
dx
=
df
dg
dg
dx
= f

(g)g

(x)
5.2 Implicit function theorem
Consider the equation f(y, x
1
, . . . , x
m
) = 0 and
the solution ( y, x
1
, . . . , x
m
). If f( y, x)/y =
0, then there exists an implicit function y =
y(x
1
, . . . , x
m
) that satises the equation for every
(x
1
, . . . , x
m
) in the neighborhood of ( x
1
, . . . , x
m
),
i.e., f(y(x
1
, . . . , x
m
), x
1
, . . . , x
m
) = 0. Further-
more, the partial derivatives are given by
y( x
1
, . . . , x
m
)
x
i
=
f( y, x
1
, . . . , x
m
)/x
i
f( y, x
1
, . . . , x
m
)/y
5.3 Matrix calculus
5.3.1 Scalar-valued functions
For a scalar-valued function f(x
1
, . . . , x
n
), the gra-
dient is
f(x)
x
=
_

_
f/x
1
.
.
.
f/x
n
_

_
and the second derivatives matrix (Hessian) is
H =

2
f
xx

=
_

2
f
x
1
x
1

2
f
x
1
x
2

2
f
x
2
x
1

2
f
x
2
x
2
.
.
.

2
f
x
n
x
n
_

_
5.3.2 Some rules
Let a, x be vectors and A a (k.n) matrix.
da

x/dx = a
d Ax
..
k.n.1
/dx = A

..
n.k
dAx/dx

= A
Let A now be square (n.n).
d x

Ax
. .
1.n.n.1
/dx = (A+A

)x
= 2Ax, for symmetric A
dx

Ax/dA = xx

..
n.1.n
7
Chain rule. For functions g : R
S
R
N
and
f : R
N
R
M
,
D
x
f(g(x))
. .
M.S
= Df(g(x))
. .
M.N
. Dg(x)
. .
N.S
Taylor rule. For f : R
N
R
1
,
f(a +h) = f(a) +Df
a
.h
. .
1.N.1
+
1
2
h

.D
2
f
a
.h
. .
1.N.N.1
+rem.
Also written with a = x
0
, h = x x
0
.
5.4 Concave function
A function f : R
N
R
1
is concave if
f(ax + (1 a)y) af(x) + (1 a)f(y),
x, y R
N
and a [0, 1].
Theorem 5.1. The twice continuous dierentiable
function f : R
N
R
1
is concave i D
2
f(x) is neg-
ative semidenite x R
N
. If D
2
f(x) is negative
denite x R
N
, then f is strictly concave. In the
special case f : R R, if d
2
f(x)/dx
2
< 0, then f
is strictly concave .
5.5 Integrals
Fundamental Theorem of Calculus. Suppose
that F is a function with continuous derivative F

=
f. Then,
_
b
a
f(x) dx =
_
b
a
F

(x) dx = F(b) F(a)

An alternative way of stating the theorem is
d
dx
_
x
a
f(y) dy = f(x)
Theorem 5.2. If f is nonnegative and integrable,
and if F(x) =
_
x

f(t) dt, then F

(x) = f(x) ex-

cept on a set o Lebesgue measure 0. (This is thm
31.3 in Billingsley)
6 Stochastic Calculus
6.1 Standard Brownian motion or
standard Wiener Process
6.1.1 Denition ...
6.1.2 Multiplication rules
1. ( dW)
2
= dt
2. dW dt = 0
3. ( dt)
2
= 0
6.2 It os Lemma
Let X be a generalized be generalized Wiener pro-
cess, like dX = aX dt + bX dW or dX = k(m
X) dt +bX dW. Let f = f(X, t). Then,
df =
f
t
dt +
f
X
dX +
1
2

2
f
X
2
( dX)
2
7 Optimization
7.1 Unconstrained optimization
The problem is to maximize
x
f(x) or
minimize
x
f(x). The rst-order condition
(necessary, but not sucient) for an optimum
is:
foc: f

(x

) = 0
Once the foc is satised, the (sucient) second-
order condition is:
soc: f

(x

)
_
< 0 for a maximum
> 0 for a minimum
Note: the optimum can occur at f

(x

) = 0, hence
the necessary soc are 0 or 0.
For a function of several variables, the foc are
Gradient = 0 and the soc is that the Hessian must
be negative (for max) or positive (for min) denite.
8
7.2 Equality constraints
The problem is
maximize
x
f(x)
s.t. c
1
(x) = 0
c
2
(x) = 0
. . .
c
J
(x) = 0
where x is a vector (n 1) and c
j
are real-valued
functions. One possibility is to substitute out the
constraints into the objective function. The general
method is to form the Lagrangian:
L = f(x) +
J

j=1

j
c
j
(x)
where
j
are Lagrange multipliers. The foc are:
L
x
= 0 (n equations)
L

= 0 (J equations)
8 Finance
8.1 Utility
Common utility functions:
CRRA: U(W) =
_
ln(W) , = 1
W
1
/(1 ) , > 1
CARA: U(W) = exp(W)
Quadratic: U(W) = aW bW
2
Coecients of risk aversion:
ARA(W) := U

(W)/U

(W)
RRA(W) := WU

(W)/U

(W)
The indierence probability to accept/reject the
simple dollar lottery (+$h, $h, ) is

=
1
2
+
1
4
h ARA(W)
and for the relative lottery (W, W, ) is

=
1
2
+
1
4
RRA(W)
Certainty Equivalent (CE). The CE of the
risky investment

Z is such that
E[U(W +

Z)] = U(W +CE)
8.2 Stochastic Dominance
1st-order SD
F
a
(x) 1SD F
b
(x)

F
a
(x) F
b
(x), x

E
a
[U(x)] E
b
[U(x)], nondecreasing U
2nd-order SD
F
a
(x) 2SD F
b
(x)

_
x

F
a
(s) ds
_
x

F
b
(s) ds, x

E
a
[U(x)] E
b
[U(x)],
nondecreasing and concave U
8.3 Mean-Variance Frontiers
Let r be the vector of returns on the N risky assets,
V := Cov(r) the covariance matrix, r := E[r] the
vector of expected returns, and 1 a vector of ones.
Dene scalars A := 1

V
1
r, B := r

V
1
r, C :=
1

V
1
1, and D := BC A
2
. Let be the required
return on the portfolio.
8.3.1 Only risky assets
A frontier portfolio (w

) is the solution to
minimize
w
w

V w, s.t. w

r = and w

1 = 1, and is
given by
w

=
C A
D
V
1
r +
B A
D
V
1
1
The portfolio variance can be computed as
V ar(w

r) = w

V w

, resulting in the mean-

variance frontier:
Var[r

p
] =
C
D
_

A
C
_
2
+
1
C
9
8.3.2 With a risk-free asset
Let the N + 1 asset be risk free, with return
r
f
. A frontier portfolio (w

) is the solution to
minimize
w
w

V w, s.t. w

r + (1 w

1)r
f
= , and
is given by
w

=
r
f
H
V
1
( r r
f
1)
with H := ( rr
f
1)

V
1
( rr
f
1) = B2Ar
f
+Cr
2
f
.
The mean-variance frontier is:
Var[r

p
] =
( r
f
)
2
H
This draws a straight line, in (
p
, r
p
)-space,
through r
f
and the tangency portfolio. The weights
in the tangency portfolio are:
w

T
=
V
1
( r r
f
1)
ACr
f
8.4 CAPM
The CAPM states that in equilibrium the market
portfolio (M) is mean-variance ecient. Ecient
portfolios lie on the Capital Market Line:
CML: E[r
p
] = r
f
+
E[r
M
] r
f

p
The cross-sectional implication is that all portfolios
lie on the Security Market Line:
SML: E[r
i
] = r
f
+ (E[r
M
] r
f
)
i
where
i
Cov(r
i
, r
M
)/ Var(r
M
) =
i
/
M
.
8.5 APT
If returns are generated by K factors,
r
j
= a
j
+
K

k=1

jk
f
k
+
j
, j
then, if there are no (asymptotic) arbitrage oppor-
tunities in a large economy,
E[r
j
] r
f
+
K

k=1

jk
( E[f
k
] r
f
) , j
8.6 Fama-French
The expected excess return on asset j is given by
E[r
j
] r
f
=
jM
( E[r
M
] r
f
)+
+
js
E[SMB] +
jh
E[HML]
where the loadings (
jM
,
js
,
jh
) are the slopes in
the time-series regression
r
j
r
f
= a
j
+
jM
(r
M
r
f
)+
js
SMB+
jh
HML+
j
and the factors are the return spreads from the fol-
lowing portfolios
50th ME prct
Small Value Big Value > 70th BE/ME prct
Small Neutral Big Neutral
Small Growth Big Growth < 30th BE/ME prct
8.7 Performance measures
Jensens alpha. Measures the return deviation
from the CAPM (or another multifactor model by
putting more factors on the right). Can be esti-
mated as the intercept in
r
pt
r
ft
=
p
+
p
(r
Mt
r
ft
) +
pt
Treynor Index. E[r
p
r
f
]/
p
Sharpe Ratio. E[r
p
r
f
]/std(r
p
). The historical
annual value for the US is about 0.5.
8.8 Arrow-Debreu pricing
Consider a nite number of states S. Let p
ad
(s) be
the Arrow-Debreu price for state s. The price of
any complex security is
p =
S

s=1
x(s) p
ad
(s)
where x(s) is the payo in state s.
8.9 Risk-Neutral Pricing
The price of any complex security is
p =
E
Q
[x]
1 +r
f
The risk-neutral probabilities,
Q
, are related to
AD-prices by
Q
(s) =
p
ad
(s)

S
s=1
p
ad
(s)
10
Theorem 8.1. (First fundamental theorem of math-
ematical nance) There exists a risk-neutral proba-
bility measure Q if and only if there are no arbitrage
opportunities.
Theorem 8.2. (Second fundamental theorem of
mathematical nance) Assume that the market is
arbitrage free. Then, the market is complete if and
only if the risk-neutral measure is unique.
8.10 Consumption Asset Pricing
8.10.1 Fundamental equation
The investor chooses z
t+1
(the quantity of the se-
curity to hold from t to t + 1) to
maximize
{z
t
}

t=1
E
0
_

t=0

t
U(c
t
)
_
s.t. c
t
+z
t+1
p
t
= z
t
x
t
, t
where x
t
is the assets total payo (for stocks, x
t
=
p
t
+d
t
).
The foc for z
t+1
is
p
t
= E
t
_

(c
t+1
)
U

(c
t
)
x
t+1
_
or, dening the stochastic discount factor as m
t+1
,
p
t
= E
t
[m
t+1
x
t+1
]
8.10.2 Relation to AD prices
For each state s = 1, . . . , S
m(s) =
p
ad
(s)

P
(s)
where
P
(s) is the (objective) probability of state
s.
8.10.3 Relation to RN probabilities
m(s) =
1
(1 +r
f
)

Q
(s)

P
(s)
8.10.4 Risk Premiums
The foc condition implies
p
t
=
E
t
[x
t+1
]
R
f
t+1
+ Cov
t
(m
t+1
, x
t+1
)
or, in return form,
E
t
[r
j
t+1
] r
f
t+1
= (1 +r
f
t+1
) Cov
t
(m
t+1
, r
j
t+1
)
8.10.5 Relation to the CAPM
If the sdf is specied directly on the return of the
market portfolio (instead of marginal utility of con-
sumption), m
t+1
= a +bR
M
t+1
, then the foc implies
the traditional CAPM.
8.10.6 Consumption CAPM (CCAPM)
Let r
c
be the return on the portfolio most
highly correlated with consumption growth. De-
ne the consumption beta of security j as
j,c

Cov
t
(r
j
t+1
, c
t+1
)/ Var
t
(c
t+1
). The CCAPM states
that
E
t
[r
j
t+1
] r
f
t+1
=

j,c

c,c
_
E
t
[r
c
t+1
] r
f
t+1
_
8.11 Black-Scholes
The stock price, S
t
, follows a GBM with volatility
. Let r be the risk-free interest rate, T the matu-
rity of the option, and X its strike price. The price
of an European call option is:
c
t
= S
t
N(d
1
) Xe
r(Tt)
N(d
2
)
and the price of the European put is
p
t
= Xe
r(Tt)
N(d
2
) S
t
N(d
1
)
where N(.) is the standard normal c.d.f. and
d
1
=
ln(S
t
/X) + (r +
2
/2)(T t)

T t
d2 =
ln(S
t
/X) + (r
2
/2)(T t)

T t
= d
1

T t
8.11.1 Greeks
Delta:
c
t
S
t
= N(d
1
)
8.12 Value-at-Risk
Let the return on an asset over a n-day horizon be
r N(,
2
). The critical value r

= z

satis-
es Pr[r r

] = , where z

is a critical value from

the standard normal distribution (typical values in-
clude z
1%
= 2.326, z
2.5%
= 1.96, z
5%
= 1.645). Let
V be the current value invested in the asset. Over
11
n days, the maximum loss with a condence level
of 1 is
V aR
n
1
= V exp() V exp(r

)
For small n, it is reasonable to assume = 0, which
leads to V aR
n small
1
V z

9 L
A
T
E
Xtricks
argmin, maximize, etc In the preamble, put
\DeclareMathOperator*{\argmin}{arg\,min}.
This creates the operator \argmin. The *-form
allows for proper placement of subscripts in both
inline and displayed math, as in arg min
x
f(x) and
arg min
x
f(x)
Note: this requires the amsmath package. Without
this package,
\def\argmin{\mathop{\textrm{arg\,min}}}
will also work.
12