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A Discussion of Financial Economics in Actuarial Models A Preparation for the Actuarial Exam MFE/3F

Marcel B. Finan Arkansas Tech University

c All Rights Reserved

Preliminary Draft

2

For Pallavi and Amin

Preface

This is the third of a series of books intended to help individuals to pass actuarial exams. The present manuscript covers the financial economics segment of Exam M referred to by MFE/3F. The flow of topics in the book follows very closely that of McDonald’s Derivatives Markets. The book covers designated sections from this book as suggested by the 2009 SOA Syllabus. The recommended approach for using this book is to read each section, work on the embedded examples, and then try the problems. Answer keys are provided so that you check your numerical answers against the correct ones. Problems taken from previous SOA/CAS exams will be indicated by the symbol . This manuscript can be used for personal use or class use, but not for commercial purposes. If you find any errors, I would appreciate hearing from you: mfinan@atu.edu

Marcel B. Finan Russellville, Arkansas May 2010

3

4

PREFACE

Contents

Preface

3

Parity and Other Price Options Properties

 

9

1 A Review of Options

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10

2 Put-Call Parity for European Options

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22

3 Put-Call Parity of Stock Options

 

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28

4 Conversions and Reverse Conversions .

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36

5 Parity for Currency Options

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41

6 Parity of European Options on Bonds

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46

7 Put-Call Parity Generalization

 

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51

8 Labeling Options: Currency Options

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57

9 No-Arbitrage Bounds on Option Prices

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62

10 General Rules of Early Exercise on American Options

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69

11 Effect of Maturity Time Growth on Option Prices

 

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78

12 Options with Different Strike Prices but Same Time to Expiration

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84

13 Convexity Properties of the Option Price Functions

 

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90

Option Pricing in Binomial Models

 

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14 Single-Period Binomial Model Pricing of European Call Options

 

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100

15 Risk-Neutral Option Pricing in the Binomial Model: A First Look

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109

16 Binomial Trees and Volatility

 

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114

17 Multi-Period Binomial Option Pricing Model

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120

18 Binomial Option Pricing for European Puts .

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125

19 Binomial Option Pricing for American Options .

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131

20 Binomial Option Pricing on Currency Options

 

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137

21 Binomial Pricing of Futures Options .

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143

22 Further Discussion of Early Exercising

 

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149

23 Risk-Neutral Probability Versus Real Probability .

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155

5

6

CONTENTS

24 Random Walk and the Binomial Model

 

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165

25 Alternative Binomial Trees

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171

26 Estimating (Historical) Volatility .

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177

The Black-Scholes Model

 

183

27 The Black-Scholes Formulas for European Options .

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184

28 Applying the Black-Scholes Formula To Other Assets

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191

29 Option Greeks: Delta, Gamma, and Vega .

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201

30 Option Greeks: Theta, Rho, and Psi .

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209

31 Option Elasticity and Option Volatility

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216

32 The Risk Premium and Sharpe Ratio of an Option .

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223

33 Profit Before Maturity: Calendar Spreads

 

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231

34 Implied Volatility

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236

Option Hedging

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35 Delta-Hedging

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244

36 Option Price Approximations: Delta and Delta-Gamma Approximations

 

252

37 The Delta-Gamma-Theta Approximation and the Market-Maker’s Profit

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38 The Black-Scholes Analysis

 

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265

39 Delta-Gamma Hedging

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270

An Introduction to Exotic Options

 

275

40 Asian Options

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276

41 European Barrier Options

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282

42 Compound European Options

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288

43 Chooser and Forward Start Options

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294

44 Gap Options .

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302

45 Exchange Options .

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308

The Lognormal Stock Pricing Model

 

315

46 The Normal Distribution

 

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316

47 The Lognormal Distribution

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327

48 A Lognormal Model of Stock Prices

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332

49 Lognormal Probability Calculations

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340

50 Conditional Expected Price and a Derivation of Black-Scholes Formula

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347

CONTENTS

7

Option Pricing Via Monte Carlo Simulation

 

353

51 Option Valuation as a Discounted Expected Value

 

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354

52 Computing Normal Random Numbers

 

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359

53 Simulating Lognormal Stock Prices

 

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364

54 Monte Carlo Valuation for European Options .

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367

55 Monte Carlo Valuation of Asian Options

 

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372

56 Control Variate Method

 

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379

57 Antithetic Variate Method and Stratified Sampling .

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386

Brownian Motion

391

58 Brownian Motion

 

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392

59 Arithmetic Brownian Motion

 

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398

60 Geometric Brownian Motion

 

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403

61 Ito Process Multiplication Rules

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407

62 Sharpe ratios of Assets that Follow Geometric Brownian Motions .

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412

63 The Risk-Neutral Measure and Girsanov’s Theorem

 

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419

64 Single Variate Itˆo’s Lemma

 

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423

65 Valuing a Claim on S a

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429

The Black-Scholes Partial Differential Equation

 

435

66 Differential Equations for Riskless Assets

 

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436

67 Derivation of the Black-Scholes PDE

 

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440

68 The Black-Scholes PDE and Equilibrium Returns

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446

69 The Black-Scholes Equation and the Risk Neutral Pricing .

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450

Binary Options

453

70 Cash-or-Nothing Options

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454

71 Asset-or-Nothing Options

 

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460

72 Supershares

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