Review sheet for Exam 1 Chapter 1-4 Chapter 1 1.

Understand the basic notations and assumptions of the simple market model. Be able to calculate the returns on the bond and on the stock. 2. Be able to calculate the value of the portfolio and the corresponding return on the portfolio at dierent times. 3. Understand the denition of long position and short position. Understand short sale denition, which is a way of borrowing money. 4. Important: Understand the No Arbitrage Principle. Be able to apply the No Arbitrage Principle to prove the problems. 5. Be able to calculate the Risk and Return of the portfolio. 6. Understand the Forward contract denition. Understand the denition of spot price and the payo of the forward contract at expiration date. Be able to sketch the diagram of the payo function. 7. Understand the calculation of forward price. Be able to use the No Arbitrage principle to prove if arbitrage opportunity exists. 8. Understand the denitions of Call options and Put options. Understand the process of replication the option. Be able to calculate the payo at the expiration date. Understand the calculation of the premiums of call options and put options. Be able to use the No Arbitrage principle to prove if arbitrage opportunity exists. Chapter 2 1. Understand the time value of Money. Be able to calculate the present values and future value/accumulated value of the cash ows by using annual eective interest and continuously compound interest. 2. Understand the denition of zero coupon bond. Be able to calculate the purchased price (present value of the face amount) of the zero coupon bond. Chapter 3 1. Be able to calculate the expected return and the risk of a single investment under dierent scenarios. Understand the denition and calculation in Example 3.2 on page 55. 2. Understand the denition of weight. Given two securities, be able to calculate the expected return and the risk. 3. Understand the denitions of feasible set,dominated security, ecient portfolio and ecient frontier.Be able to state the ideas of how to sketching the diagram of ecient frontier. Chapter 4 1. Be able to evaluate the forward price (both non-dividend stock and dividend stock) and the value of the forward (both non-dividend stock and dividend stock) at dierent exchanged times. We discussed two cases of dividends in class. Pay xed amount of dividend and xed dividend rate. Be able to use the No Arbitrage Principle to prove if arbitrage opportunity exists. Note: (1) All calculation in Chapter 4 are under continuously compound interest rates. (2) The value of the forward depends on the position of the forward contract. 1

2. Understand the denition of future contracts. Understand Closing out Position and be able to specify a future contract. Understand daily settlement, initial margin, maintenance margin and the margin call. Be able to do the corresponding calculation manually. Understand the dierence between forward and future. 3. Understand the pricing of future contracts. Be able to calculate the price of stock index futures and futures on commodities. 4. Understand the basic principle of hedging. Understand basic risk. Be able to calculate the eective price under hedging with futures. 5. Understand the Capital Asset Pricing Model (CAPM). Be able to calculate the number of futures used for hedging. Be able to calculate the expected return of the portfolio by using CAPM. Be able to evaluate the expected value of the hedgers position if the stock index price changes. Please refer to the class notes for the material of futures. NOTE: You are responsible for all homework problems. Go over all class examples and quizzes problems. No formula sheet will be given in the test.

Some of the formulas in Chapter 1-4 1. Value of the portfolio at time t of x shares of stock and y bonds, with stock price S(t) and bond price A(t) is V (t) = xS(t) + yA(t) 2. Return of the Stock KS and the Bond KA . )S(0) )A(0) KS = S(TS(0) KA = A(TA(0) 3. Expected return of the stock and the risk of the stock Expected return = = E(KS ) = KS1 p1 + KS2 p2 + + KSn pn Risk =S = V ar(KS ) = E((KS )2 ) = (KS1 )2 p1 + (KS2 )2 p2 + + (KSn )2 pn Similarly for portfolio expected return and risk calculation. 4. Payo to Long forward = Spot Price - Forward Price = S(T ) F . Payo to Short forward = Forward Price - Spot Price = F S(T ). Forward price = S(0)(1 + KA ) 5. Payo to Long position of call option C(T ) = max(0, S(T ) K) Payo to Long position of put option P (T ) = max(0, K S(T )) where K is the Exercise/Strike price of the option. 6. A portfolio consisting of two securities S1 with weight w1 and S2 with weight w2 : Return on the portfolio = KV = w1 K1 + w2 K2 Expected return on the portfolio = E(KV ) = w1 E(K1 ) + w2 E(K2 ) 2 2 Variance of the return on the portfolio = V ar(KV ) = w1 V ar(K1 )+w2 V ar(K2 )+2w1 w2 Cov(K1 , K2 ) Risk of the portfolio = V ar(KV ) 7. If interest rate is a constant, then forward price is equal to future price. (r is the continuously compound interest rate) (1) For non-dividend stock, the forward price is F (0, T ) = S(0)erT (forward is exchanged at 0 and delivered at T ) F (t, T ) = S(t)er(T t) (forward is exchanged at t and delivered at T ) (2) For dividend stock paying dividend D at time t, where 0 < t < T , Forward price is F (0, T ) = (S(0) Dert )erT (3) For dividend stock paying dividend at a rage of q, Forward price is F (0, T ) = S(0)e(rq)T , F (t, T ) = S(t)e(rq)(T t) Note: We only consider the dividend paying after the forward or future contract exchanged when we calculate the forward or future prices. 8. Value of Forward contract initiated at t = 0 and delivered at T : Long forward V (t) = [F (t, T ) F (0, T )]er(T t) Short forward V (t) = [F (t, T ) F (0, T )]er(T t) 9. Capital Asset Pricing Model (CAPM) Expected return of the asset = Rf + (RM Rf ), where Rf is the risk free rate and RM is the expected return of the market.

10. The number of futures used for hedging VA N = VF , where VA is the current value of the portfolio and VF is the current value of one future contract.