F70CF Continuous-time Finance – FORMULA SHEET

Itô’s formula

(a) Let X = (Xt )t≥0 and Y = (Yt )t≥0 be Itô processes, and let f be a smooth function of two
real variables. Then the stochastic process f (Xt , Yt ) is also an Itô process, satisfying
∂f ∂f
df (Xt , Yt ) = (Xt , Yt )dXt + (Xt , Yt )dYt
∂x ∂y
 2
∂2f ∂2f

1 ∂ f
+ (Xt , Yt )d[X]t + 2 (Xt , Yt )d[X, Y ]t + 2 (Xt , Yt )d[Y ]t ,
2 ∂x2 ∂x∂y ∂y
where [.]t denotes the quadratic variation process, and [., .]t denotes the quadratic covariation
process. If we can write dXt and dYt in the form
dXt = µt dt + σt dWt ,
dYt = µ0t dt + σt0 dWt ,
where Wt is a standard Brownian motion, then the stochastic differentials d[X]t etc. can be
calculated using the multiplication table
dWt dt
dWt dt 0
dt 0 0
as follows:
d[X]t = (dXt )2 = (µt dt + σt dWt )2 = σt2 dt,
d[X, Y ]t = dXt dYt = (µt dt + σt dWt )(µ0t dt + σt0 dWt ) = σt σt0 dt,
d[Y ]t = (dYt )2 = (µ0t dt + σt0 dWt )2 = (σt0 )2 dt.

(b) Let X = (Xt )t≥0 be an Itô process, and let f be a smooth function of two real variables.
Then the stochastic process f (t, Xt ) is also an Itô process, satisfying
1
df (t, Xt ) = f˙(t, Xt )dt + f 0 (t, Xt )dXt + f 00 (t, Xt )d[X]t .
2
(c) Let X = (Xt )t≥0 be an Itô process, and let f be a smooth function of one real variable. Then
the stochastic process f (Xt ) is also an Itô process, satisfying
1
df (Xt ) = f 0 (Xt )dXt + f 00 (Xt )d[X]t .
2
(d) If Wt is a standard Brownian motion, and f is a smooth function of two real variables then
 
1 00
df (t, Wt ) = f (t, Wt ) + f (t, Wt ) dt + f 0 (t, Wt )dWt .
˙
2
(e) If Wt is a standard Brownian motion, and f is a smooth function of one real variable then
1
df (t, Wt ) = f 0 (Wt )dWt + f 00 (Wt )dt.
2

[Continued...]

1
Jensen’s inequality

If X is a non-negative random variable on a probability space (Ω, F , P), and f : [0, ∞) → R is a

convex function then
EP [f (X)] ≥ f (EP [X]).
If G is a sub-σ-algebra of F then

EP [f (X)|G ] ≥ f (EP [X|G ]).

Forward Prices

Let r denote the continuously compounded, risk-free rate of interest.

• For a non-dividend-paying risky asset, the forward price (at time t) for delivery of one unit
of the risky asset S at time T is
FtT = er(T −t) St .

• The forward price (at time t) for delivery of one unit of foreign currency at time T is

FtT = e(r−rf )(T −t) Et

where rf is the (continuously compounded) rate of interest on the foreign riskless asset, and
Et is the exchange rate (i.e. the price of one unit of foreign currency) at time t.

• For a share S paying discrete dividends of δSt− at known times T1 , T2 , . . . , the forward price
(at time t) for delivery of one share at time T is

FtT = (1 − δ)n[t,T ] er(T −t) St ,

where n[t, T ] is the number of dividends paid in the time interval [t, T ].

• For a share index I paying continuous dividends at a rate qIt dt over an infinitesimal time
period dt, the forward price (at time t) for delivery of one unit of the share index at time T
is
FtT = e(r−q)(T −t) It .

In general,
FtT = erT (St − time t value of remaining dividends).

[Continued...]

2
The Black-Scholes Model

A riskless asset B and risky asset S are modelled as

Bt = exp(rt)
   
1 2 1 2
St = S0 exp (µ − σ )t + σWt = S0 exp (r − σ )t + σ W̃t ,
2 2
where r, S0 , µ and σ are positive constants, Wt is a Brownian motion under the real-world measure
P, and W̃t Brownian motion under the risk-neutral measure Q.

The Black-Scholes Formulae

Let Z d
1 − 1 z2
φ(z) := √ e 2 and N [d] := φ(z)dz.
2π −∞
denote respectively the density function and the cumulative distribution function for a standard
normal random variable.

• The time t price of a European call option on a non-dividend-paying risky asset (under the
Black Scholes model) is
ct = St N [d+ ] − e−r(T −t) KN [d− ]
where
St
+ (r ± 21 σ 2 )(T − t)


ln K
d± = p .
σ (T − t)
The formula for the price, pt , of a put option on a non-dividend-paying risky asset can be
calculated from put-call parity:

pt = ct + e−r(T −t) K − St .

• The time t price of a European call option (under any of the extended Black Scholes models)
is
ct = e−r(T −t) (FtT N [d+ ] − KN [d− ])
where
FtT
 
ln K ± 12 σ 2 (T − t)
d± = p ,
σ (T − t)
and FtT is the relevant forward price for delivery of the underlying asset at time T .
The formula for the price, pt , of a put option in the extended Black Scholes models can be
calculated from put-call parity:

pt = ct + e−r(T −t) (K − FtT ).

[Continued...]

3
The Black-Scholes Partial Differential Equation (PDE)

∂p ∂p 1 2 2 ∂ 2 p
+ rs + σ s = rp.
∂t ∂s 2 ∂s2

The Greeks

For a derivative contract with pricing function p(t, s; σ, r), the Greeks are given as follows:

∂p ∂2p ∂p
∆= (t, St ), Γ= (t, St ), Θ= (t, St ),
∂s ∂s2 ∂t
∂p ∂p
κ= (t, St ), ρ= (t, St ).
∂σ ∂r

Finite Difference Methods

∂p ∂p pi,j+1 − pi,j
Forward difference approximation for : ≈ ,
∂s ∂s δS
∂p ∂p pi,j − pi,j−1
Backward difference approximation for : ≈ ,
∂s ∂s δS
∂p ∂p pi,j+1 − pi,j−1
Symmetric difference approximation for : ≈ ,
∂s ∂s 2δS
∂p ∂p pi+1,j − pi,j
Forward difference approximation for : ≈ ,
∂t ∂t δt
∂p ∂p pi,j − pi−1,j
Backward difference approximation for : ≈ .
∂t ∂t δt

∂2p
Difference approximation for :
∂s2
pi,j+1 − pi,j pi,j − pi,j−1
∂2p − pi,j+1 − 2pi,j + pi,j−1
≈ δS δS = .
∂s2 δS δS 2

[Continued...]

4
Term Structure

From the price P (t, T ) of a bond, the following continuously compounded rates of interest can be
derived as follows:

(a) The forward interest rate for the time interval [T, T 0 ], contracted at t
ln P (t, T 0 ) − ln P (t, T )
f (t, T, T 0 ) := − .
(T 0 − T )

(b) The spot interest rate R(t, T ) for the time interval [t, T ]
ln P (t, T )
R(t, T ) := − .
(T − t)

(c) The forward interest rate for instantaneous borrowing at time T contracted at time t
∂
f (t, T ) := − ln P (t, T ).
∂T
(d) The short rate (instantaneous spot rate) at time t

∂ 
rt = f (t, t) = − ln P (t, T ) .
∂T T =t

Models of the short rate rt

Let W̃t be a standard Brownian motion under the risk neutral measure Q, and let a, b and σ be
positive constants.

• Vasiček
drt = a(b − rt )dt + σdW̃t r0 = constant;

• Cox-Ingersoll-Ross (CIR)
√
drt = a(b − rt )dt + σ rt dW̃t r0 = constant.

Under the Vasiček model, the price at time t of a zero coupon bond which pays one unit of currency
at time T ≥ t is given by
P (t, T ) = eA(t,T )−B(t,T )rt ,
where
σ2 σ2
 
A(t, T ) = b − 2 [B(t, T ) − T + t] − B(t, T )2
2a 4a
1
B(t, T ) = [1 − e−a(T −t) ].
a

[End Of Formula Sheet]