1 MTHEMATICAL METHODS

1.1 SERS
Z
Exponential function
x
2
x
3
exp(
x
)=ex =1+
x+-
+
-
+
'"
2! 3!
Natural log fncton

x3
log(l +x)
=
I(l +x) =

--+--. . (-1
<
x: 1)
2 3
Binomal expansion
where n is a positive i
n
teger
(l +
x
)p
= 1 + px
(
pCP -1)
x
2
+
pCP
-l)
(
p
-
2
)
x
3
+
.
.
.
2! 3!
(-I<x<l)
1.2 CALCULUS
Taylor series (one variable)
h
2
fe
x
+h
) =
f(
x
) 7hf'(
x
) +
-
f
"(x)
+
...
2!
Taylor series (two variables)
f(
x
+ h,y + k)
=
f(
x
,y)
+
hf(
x
,y) +kf;(
x
,y)
+

!
(h
2
f
(x
,y) + 2hk f; (
x
,y)
+ k
2
f;(x
,y
)
+
..
.
Integraton by parts
f b d
b
f b du
u-m=[uv] - v-m
a
m
a
a
m
Double integrals (changing the order of integration)
The domain of integration here is the set of values
(
x,
y
) for which
a
<
y
<x<b
.
Diferentiating an integral
d
bey
)
_
f
f(
x
,y)
m =b
'(y)f[b
(y),y] -a'(y)f[a(y),y]
Ya(y)
bey
)
a

f
_
f
(
x
,y)
d
a
Cyl
Y
J
1.3 SOLVING EQUATIONS
4
Newton-Raphson method
If x is a sufciently good approximation to a root of the equation
lex
) = 0 then (provided convergence occurs) a beter approximation
IS
*
lex
)
x =x--.
{'(x)
Integratng factors
The integrating factor for solving the differential equation
dy .
-+ P(x)y = Q(x) IS:
d
exp(J P(x)d)
Second-order diference equatons
The general solution of the difference equation
al+
2
+ bXn+1
+
cXn = 0 is:
if b
2
-4ac > 0: Xn = AAJ + BA
(distinct real roots, A
l "
1
2
)
if b
2
-4ac =0: xi = (A + Bn)A
n
(equal real roots, Al = 12 = A)
if b
2
-4ac < 0:
x
n = rll(Acosn8 + Bsinn8)
(complex roots, A
l
=

2
= rei6)
where Al and 1
2
are the roots of the quadratic equation
aA
2
+bA+C=O.
1.4 GAMMA FUNCTION
1.5
Defnition
I
(
x) ftX-le-t
d
t, x>0
0
Properties
rex
)
= (x-!)I(x-!)
I
tn) (n-)'. n 1,2,3
, ...
BAYES' FORMULA
Let AI> A
2
, ...
,
A
n be a collection of uHally exclusive ad exhaustive
events with P(A_ )# 0, I,1, ... ,n
For any event
B
such that PC
B
) 0:
P(AiI
B)
=
P(BIA
i
)P(
A
J
,
i=I,2, ... ,n

n
L
P
(BIA
j
)P(Aj)
j=l
3
1 b1A1b1LA Ub1H1LDb
Notaton
PF Probabilit fnction, p(x)
PDF Probability density fnction, f(x)
DF Distrbution fnction, F(x)
PGF Probability generating fnction,G(s)
MGF Moment generating fnction, M(t)
Note. Were formulae have been omitted below, this indicates that
(a) there is no simple forla or (b) the fnction does not have a
fnite value or (c) the fnction equals zero.
2.1 DISCRTE DISTRBUTIONS
6
Binomial distribution
Parameters:
PF:
DF:
PGF:
MGF:
Moments:
Coefcient
n, p (n = positive integer, 0 < p <1 with q= 1- p)

n
x n-x
p(x)=
l
x
p q , x=O,I,2, ... ,n
The distbution fnction is tbulated in the statistical
tables section.
G(s) = (q+ ps)
n
E(X) = np, vX)= npq
of skewess:
q- p
Jnpq
BernouHi distribution
The Beroulli distrbution is te same as the binomial distribution
with parameter n
=
I.
Poisson distrbution
Parameter:
PF:
DF:
PGF:
MGF:
Moments:
Coeffcient
of skewness:
f (f
~0)
e -
f
x
p
(
x
)
=-, x=O,I,2, ...
x
!
The distribution fnction is tabulated in the statistical
tables section.
G(s) = e(s-l)
M
(t
) =
e(e' -1)
E(X) = f, var(X) = f
1

Negative binomial distribution - Tye 1

Parameters:
PF:
PGF:
MGF:
Moments:
Coefcient
k, p (k
=
positie integer, 0 < p < 1 with q -1-
p)
X

k x-k
p{X
)
=

q
, x=k,k+
l
,k+2
, ...
k-
I
-

M
(t
)
=
[
p
e
t
I
)
k
I-
q
e
l()~. ()-
k
q
p
2
2
-p
of skewness:
Negative binomial distribution - Type 2
Parameters:
PF:
PGF:
MGF:
Moments:
Coefcient
of skewness:
[
p (k > O, 0 < < I wit q= 1 p )
I(
[
x\
k x
() p g x = 0,1,2, ...
I(x I)I(k)
G(S)= ,
I-qs
M (t)=-r
I-gc
(X)
[
q
var(X)=

P
2-p
j
Geometric distribution
The geometric distribution is the same as the negative binomial
distribution with parameter k = I
9
Uniform distribution (discrete)
Parameters: a, b, h (a < b, h> 0, b -a is a multiple of h)
PF:
PGF:
MGF.
Moments:
h
p(x) = , x=a,a+h,a+2h, ... ,b-h, b
b-a+h
G(s) =
" h

U
b-a+ h

h
,
,
M(t)
b-a+h
,
-1
1 I
E(X) = -
2
(a + b), va(X) = -(b -a)(b-a+ 2h)
12
2.2 CONTINUOUS DISTRIBUTIONS
10
Standard normal distributon - N(O,I)
Paameters: none
PDF:
DF:
MGF:
Moments:
The distrbution fnction is tabulated in the statistical
tables section.
E(X) = 0, va(X)
=
1
r 1 reI + r)
E(
X
) =
2
r!2 (
r
) '
r
=
2
,4,6, ...
r 1+-
2
Normal (Gaussian) distributon
-
N(

z
)
Parameters:
I,

z
(o>0)
PDF:
1

z
1 1 x-
I
/(x
)=ex
p
--
o!
2 o
/ /
MGF: M
(
t)=
,

-c
Moments:
l(*) =I, vm(X)=a
2
Exponential distributon
Parameter:
PDF:
DF:
MGF:
Moments:
Coefcient
of skewness:
\(\>0)
/(x)=A-A, x>0
F(x)=i-,
'
M
(
t)=

t\
l(*)=
I
1
vm(X)=
_
\
y I(I*)
I(X )
) =1
,
2,3
,
...
\

-L <x
<
11

12
Gamma distribution
Parameters: a, A (a>O, A>O)
PDF'. )() A
a
a
-I -A
x =-x e , x>
n
a)
DF: When 2a is an integer, probabilities for the gamma
distribution can bc found using the relationship:
MGF:
Moments:
Coeffcient
of skewness:
L2) Ig va(X) =
, ]o+r)
I2 ) = , r 1,2,3, ...
Jo)7

2
J
Chi-square distribution X
The chi-square distribution wit ' degrees of freedom is the same as
the gama distribution with parameters o

and /= ...
2 2
The distribution fnction for the chi-square distribution is tabulated in
the statistical tables section.
Uniform distribution (continuous) (a,b}
Paramctcrs: u,b( u<b)
PDF:
1
)()
=
, a<<h
b-a
DF:
l
()

x-u
b-u
MGF:
Moments: I(

)=(ub). v
ar
()=(b-u)
2 12
_
(
'

_
1

b
'
u
'
r
=I],3, o o
(b-a)r
+
l
Beta distributon
Paramctcrs: a, (a>O, >O)
PDF:
Moments:
Coefcient
of skcwncss:
(X)=_
a
_
,
var()

a

a
+
(
a
+)2
(a++
1)
(X
r
)
=
l(
a+
)l(
a+r
),
r
=1,2,3, ...
l(a)r(a+l+
r
)
2( -
a
)
a +
+ 1
(a++
2
) a
13
4
Lognormal distribution
Parameters:
PDF:
Moments:
Coefcient
I

2
)
l l 1ogx-1
f(x)= e
xp --
,x>O
O2 Z O
E
(X)

C
7
, var
(X) = C

C
~

2
-
(

)
of skewness: (C

72) C

-
-J
Pareto distrbution (two parameter version)
Parameters:
PDF:
OI:
Moments:
Coeffcient
e , A ( e>0, 1>0)
F
(
x)
~
J

A+x
A
e
A
2
E(
X
)= -(e>l), var
(
X)=
2
(>')
Q-}
(e
-
) (e
-
')
E
(
X
r
) =
'
e
-

|I
7)
= l2 ! ,

,...1
I( e)
of skewness:
'
( 1
*
J

e -
'
(e > !)
(e -!)
Pareto distribution (three parameter version)
Parameters: a, A,
k
(a>O, A>O,
k
>O)
PDF:
Moments: E
(X)=
(a>1
)
, var(X)
=
k
(
k+
a-
l)
A
2
(
a
>2
)
a-
I
(a-I)
2
(a-
2
)
Weibull distributon
Parameters: c, Y (c>O, Y>O)
PDF:
DF:
l
()=
l
-
e
-c
Y
Moments: ]('}
=
r
l '
r
= 1,2,3, . ..
Y
c
r
y
Burr distribution
Parameters: a, A, Y (a > O, A > 0, Y > O)
PDF:
DF:
Moments:
l|
)= 1 -

r
,

r
/'
(X ) =1 a-- r
1
+
- -, r=1,2,J, . ,
r
<a
y
y y
r(
a
)
15
2.3 COMPOUND DISTRIBUTIONS

Conditional expectation and variance

E(Y) E[E(Y X)]
var(Y) var[E(Y X)] E[var(Y I X)]
Moments of a compound distribution
If X1, X2, ... are lID random variables with MGF _( | and ^ is
an independent nonnegative integer-valued random variable, then
S = _ ** _ (with S 0 when / 0) has the following
properies:
Mun E(S) E(N)E(X)
|urune:

var(S) E(N)var(X) * var(N[E(X)]
MGF:
Compound Poisson distribution
Aun

m
|urunc:

m
1hrdcn ru /mmn : /m
where

= E(N) and m L(X

)
Recursive formulae for integer-valued distributions
(u ,J} c u /d ru in
Let [,
P(S r}, r U,1' and I
j
l(X=]) ]=,
If
J

I(N r) , where j, ut, J,. I' , then

,

.
,
;;
=
/;
and [,

u
t }[,.
1
r',
1=
(
r
Camjaund!in d riu n
If N has a Poisson distribution with mean A, then u and A
and
A
,
;;
,
`
and
[,[. r|.'
r

/
=I
l
2.4 1HLNLA1DmOMN1S
t
Normal distribution
!!f(x)
is the Oof the N(,(
2
) distribution, then
J x f(x)d [<(
U
') - <(L')] |(|) tI]
L
-
I
U-
I
where I= and U'= .
( c
Lognormal distribution
!f
(x)
is the Oo!the lognormal distribution with parameters
and (
2
, then
h
L
l
og
L
-
k d U
logU- _
w ere k= ( an
k=
c.
c (
|

!
^
b
M

!
^
b

O
I
b
L
H
L

(
s
a
m
0
}
)

u
m

U
9

n
.
J

[
s
a
u
0
}
!

1

-
-
_

-
.

k
q

+
l

t
`

l
o
g
A
T

-
[

L
O

1
N
1
O
1
b

}
!

'

J
.
_

-
O
A

Z
2

_
l
/
r

J
(
a

+
I

9
,

^
l

'
|
o

!
,
,

o
-
I

2
Z

-

!

;
_
k

P
a
c
o

v
.
I

.
!

,
o
-
,
-
(
o
-
{
-
i
)

|
/
}

(
8
8
m
c

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.

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-

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:

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b
i
t
r
a
r

c
o
n
s
t
a
n
t
s
.

L
i
m
i
t
i
n
g

c
a
s
e
s

(
i
n
d
i
c
a
t
e
d

b

d
o
t
e
d

l
i
n
e
s
)

F
o
r

e
x
a
m
p
l
e
,

t
h
e

a
r
r
o
w

m
a
r
k
e
d

"

=

n
p
,

n

"

c
o
n
n
e
c
t
i
n
g

t
h
e

b
i
n
o
m
i
a
l

d
i
s
t
r
i
b
u
t
i
o
n

t
o

t
h
e

P
o
i
s
s
o
n

d
i
s
t
r
i
b
u
t
i
o
n

m
e
a
n
s
:

F
o
r

l
a
r
g
e

v
a
l
u
e
s

o
f

n
,

t
h
e

b
i
n
o
m
i
a
l

d
i
s
t
r
i
b
u
t
i
o
n

w
i
t
h

p
a
r
a
m
e
t
e
r
s

n
a
d

p

w
i
l
l

a
p
p
r
o
x
i
m
a
t
e

t
o

t
h
e

P
o
i
s
s
o
n

d
i
s
i
o
n

w
i
t
h

p
a
r
a
m
e
t
e
r

,

w
h
e
r
e

=
n
p
.

3 STATISTICAL METHODS
3.1 SAMPLE MEAN AD VARIANCE
The random sample (x
!
,x
2
, . . . ,x
n
) has the following sample
moments:
Sample mean:
Sample variance: s
2
=

1
- xf - nx2 }
n - 1
i=1
3.2 PATRC INFERENCE (OR MODEL)
22
One sample
For a single sample of size n under the normal model X

N(I,c2):
x -! (n -
1
)S2 2
-

t
!
a
d
2
Xn-l
S/F
n
-
c
Two samples
F or two independent samples of sizes m and n under the noral
models X N(!x,c) and Y -N(IY,c):
sl/c
2
/
2

Fm-l,n-l
Sy cy
Under the additional assumption that O= O .
|' Y) (I !;

"
+-z
S
+
- _
m n
where S = 1 {(m -1)S1 + (n -l)Sf
}
is the pooled sample
m+n-2
variance.
3.3 MAXIMUM LIKELIHOOD ESTIMATORS
Asymptotic distribution
If 0 is the maximum likelihood estimator of a parameter e based on
a sample X, then 0 is asymptotically normally distributed with mean
e and variance equal to the Cramer-Rao lower bound
Likelihood ratio test
where !_ = max 10gL
0
and I___ * max 10gL
1_1
approximately (under H

}
is the maximum log-likelihood for the
model under H

(in which there are

] fee parameters)
is the maximum log-likelihood for the
model under T_ H
I
(in which there
are ]
+
Q fee parameters).
Z3
3.4 LINEAR REGRESSION MODEL WITH NORMAL ERRORS
24
Model
Intermediate calculations
n n

-
)
2
2 -2
sx =

x
i -
X =
X
j - nx
i=l ;=1
n n

-
)
2

2
-
2
S
y
=
Yi - Y = Yj - ny
;=1 i=1
n n
S
xy = L(
X
; - X)(Yi - y) = LXiYi - nxy
i=1 i=1
Parameter estmates
Distribution of
Variance of predicted mean response
An additional c
2
must be added to obtain the variance of the
predicted individual response.
Testing the correlation coefcient
s
-

SXSy

Ifp=O,then

'n
2

Fisher Z transformation
2_

approximately
n-3
where 2 tanh-
I
-..
-
,and 2_ * tanh-
I
.
!
'
:-- :-
Sum of squares relationship
n n n
:

y)
2
*
L
(
Yi
-
.v;)
2
O y)
2

t /=| |=|
Z3

3.5 AALYSIS OF VAACE

Z
Single factor normal model
2
_ N(1 7, ) , i = 1,2, ... ,k, j = 1,2, ... ,n;
[ [
where n = >
i
' with
_
n
;
T
;
= 0
j
= ;=1
Intermediate calculations (sums of squares)
[
0j
[
0j 2
Total:
SST = _(Yij
-
y

.
)
2
= J
_
yJ

Y

i=I=! i=I=!
n
[ [
2 2
B SS

(
- -
)
2

Y
i
Y
etee
n
treatments:

= k
n

Y
;.

Y
..
=

i=1 ;=1
n
;
n
Residual: SS _ = S
ST - SS
Variance estimate
Statstical test
Under the appropriate null hyothesis:
S
B
/
.SR
Fk-1 n8
k-l n-k
.
3.6 GENERLISED LINEAR MODELS
Exponental famy
For a random variable Y fom the exponential faly, with natural
parameter 6 and scale parameter <:
Ir.:::`'`}(JcI`]1n.|`.I ],;6, = exp
Y

:6
I
+.
:
Ac:I
E(Y) = :6
I
I:r`:I
.c var(Y) = :

(:6)
Canonical lnk functons
B`:.:'
8
l
p
)= log

1

!
I.`.:
A.r:'
C::
8

HI
=
l
og
1
8!H!= 1
1
8
l
H
)=
-
!
27
3.7 BAYESIAN METHODS
28
Relationship beteen posterior and prior distributions
P.'cr`.ro I`.rX L`u'`:..J
The posterior distribution }(0I.) for the parameter 0 is related to
the prior distribution }(0) via the likelihood fnction }(

0):
)
t
0
ID
}
t
)x
}
|\,
0
)
Normal /normal model
If . is a random sample of size n from a N(!,c
2
) distribution,
where c
2
is known, and the prior distribution for the parameter ! is
N(!o,c5 ), then the posterior distribution for ! is:

3.8 EMPIRICAL BAYES CRDIBILITY -MODEL 1
Data requirements
{Xi
,i = I,7,,A,( I,7,,n}
X
i
represents the aggregate claims in the j th year fom the i th rsk.
Intermediate calculations

I
n

1
N
Xi

LXi' X=
N
L
X
;
n
j=
l
i=1
Parameter estimaton
Qu:I'`} Lt`:.
I(
!J
A

L

var[m(8
)]
I

-
I
{
1

-
}
--.-.JX
i
-
X
) - . . Xi
X
)
N
-
1 i
=1
Nn
i=l
I

I
j
=1
Credibilit factor
z

I

E[
i
(8]
I+

var[ (8)j
29
3.9 EMPIRICAL BAYES CREDIBILITY - MODEL 2
J
Data requirements
{i,
i
=1,2, , N, } =
!,7,,n}. {P
i
,i =1,2, , N,} =1,2, ,n}
Yi represents the aggregate claims in the } th year fom the /th risk;

i is the corresponding risk volume.

Intermediate calculations
/
=
_

, l=_. =
n N

,=; |=t
N
n

=i
P
x
..
=
Yi
XI'
=

j
i
,
_@

i
'
p.'
A
P
A
J
'
,-i ,=i,-i
Parameter estimation
_so

t/
r(-
l
var[m(8)]
Ist/ot
i
j
^
[
2

*
_

- - '' P
(
X
i
-X
) -_ _1x `)
F*

n
,
~~ 'l
)
N n i
9 9
t=I ]= I= ]=]
Credibilit factor
H
2
P
i
Z
@
)
=;
l
n
s

-
2p
,-i
\-t,|-)]
4 LL%1LNO P1H51
Increasing/decreasing annuity functons
..
n
`u|

* g Ju|

Accumulation factor for variable interest rates
31
5 hLHA NtIIh
5.1 MORTALITY "LAWS"
32
Survval probabities
Gompertz' Law
Makeham's Law
x

tgc
X
(c
t
-l) -A
!x = A+Bc , (Px-s
where s=e
Gompertz-Makeham formula
The Gompertz-Makeha graduation forula, denoted by GM(r,).
states that
where t is a linear fnction of x and o/y
(
(t) and o/y
;
(t) are
polynomials of degree rand s respectively.
5.2 EMPIRICAL ESTIMA nON
Greenwood's formula for the variance of the Kaplan-Meier
estimator
- [ ,
J

"
d
j
var
[ F(t)]
=

)
@

1
,
51
n
j(
n
j -d
j
)
Variance of the N elson-Aalen estimate of the integrated hazard
5.3 MORTALITY ASSUMPTIONS
5.4
Balducci assumption
__q ___ (l
t)q
x
(x is an integer, 0 : t: l)
GENERAL MARKOV MODEL
Kolmogorov forard diferential equaton
a
y0 _
"
( /0 0 h )
at
P
x

@ l Px Ix+1 - lPx Ix+1

J
0
J3
5.5 GRADUA nON TESTS
3+
Grouping of signs test
If there are
n
, positive signs and
n
2
negative signs and G denotes the
obsered number of positive rns,lhen.
Critical values for the grouping of signs test are tabulated in the
statistical tables section for small values of and
n
2
' For larger
values of g and n
2
the normal approximation can be used.
Serial correlation test
I
"

-.
L
(zi
-
:|Zi+j -
m
-j __
r. "
I-
J

"
-
L
(Zi _:)
2
m
i=l
r

X ! N(0,!) appDximately.
Variance adjustment factor

a,
_
i

x
_/a,
l
"
where
L
Z
i
m
i=!
where x is the proportion of lives at age who have exactly l
policies.
5.6 MULTIPLE DECRMENT TALES
For a multiple decrement table with three decrements a, and y,
each unifor over the year of age (x,x +I) in its single decrement
table, then
5.7 POPULATION PROJECTION MODELS
Logistic model
1
''
(t)

k
'
(t) has general solution I(t)= p
I(t)
'
t _
pc -Pi +
[
where
_
is a constant.
35
ANN1111S ANO A55LHANLI5
6.1 APPROXIMATIONS FOR NON ANNUAL ANNUITIES
.. (
m
) ..
m-
l
L 1 _
^
2
m
((
m
) " ( m
l

D
x+n
x:;
x
:;
2
m
D
X
6.2 MOMENTS OF ANNUITIES AD ASSURCES
J
Let
K
X
and J denote thc curtate ad complete fture lifetimes
(respectively) of a lifc aged cxactly .
Whole life assurances
p
_
.
-
|
]
_

-
i_
_
:
_
____:
V __ 1
X
_
Similar relationships hold for endo.nt assurances (with status
x:; )_ pure endowments (with status
_
) ter assuraces (with
stats !:;) and deferred whole life assuraces (with stats _:_).
Whole life annuities
Similar relationships hold for temporary annuities (with status '
_
_
,
).
6.3 PREMIUMS AND RESERVES
6.4
Premium conversion relationship beteen annuites and
assurances
Similar relationships hold for endowment assurance policies (with
stats ,)
HI
Net premium reserve
a
v *
]. ^
l
l X

v
1-
^

l
^
.

X
Similar forulae hold for endowment assurance policies (with
statuses ..
.
, and )a
XH!
^
l.H!
THIELE'S DIFFERENTIAL EQUATION
Whole life assurance
Similar formulae hold for other types of policies.
Multple state model
J
7 STOCHASTIC PROCESSES
7.1 MKOV "JMP" PROCESSES
Kolmogorov diferental equations
Forard
e
quatio
n
:
Backard equation:
J
i
(s
t
)
=
_
(
i
k(S)Pk(s,t)
o
s
8e
where ( i (t) is the tansition rate fm state i to state j (j + i) at
time t, and (u =
-
_
(
i
0
f#
i
Expected time to reach a subsequent state k
7.2 BROWIAN MOTION A RELATED PROCESSES
J
Martingales for standard Brownian motion
If {Bt,t Z O} is a standard Brownian motion, then the following
processes are maingales:
Distribution of the maximum value
p
maX(
B

+) ~ = < -
Y
+
- (
e
2JY<
-
Y -
Y
_ 0
05

5t
!
Hitting times
If ' y = min {s : Bs + y} where 1 > and y < O,then
s;o
Ornstein-Uhlenbeck process
7.3 MONTE CARO METHODS
Box-Muller formulae
If UI and U2 are independent random variables fom the U(O,l)
distribution ten
are independent standard noral variables.
Polar method
If J and |
-
are independent random variables fm the U(-l,l)
distribution ad S [
-
+vl then, conditional on < S 1 ,
are independent standard noral variables.
Pseudorandom values fom the U(O,l) distribution and the N(O,l)
distbution are included in the statistical tables section.
39
8 TIME SERES
8.1 TIME SERIES - TIME DOMAIN
40
Sample autocovariance and autocorrelation function
Autocovaria
n
ce:
Autocorrelatio
n
:
I n 1 n
. , ,
Yk
=- ( xt
-
1)(xl -
k
-1)' wh
ere
=
-LX
n
l=
k
+1
n
1=1
,
Yk
Pk
=
-,
Yo
Autocorrelation function for AMA(l,l)
For the process
Xt = al_1 + el +
e
l_l:
Partial autocorrelation function
*
_ detPk _
< ---, k-2,3, . . . ,
det/
PI
w
here P
k
=
P2
PI
1
PI
P2
PI
1
Pk-I Pk-2 Pk-3
Pk-I
Pk-2
Pk-3
and P; equals P
k
, but with the last column replaced with
T
(PI,P2,P3"",Pk) .

Partial autocorrelation function for MA(1)
For the process
\

=
1
+

+
-i
g (-!)
t+;

k
=
I,2,3, ...

8.2 TIME SERIES - FREQUENCY DOMAIN

Spectral density function

j

{
j
. <m<?
t

Inversion formula
Spectral density function for ARMA(,q)
The spectral density fnction of the process ()(X - ) O()e,
where yare

) o',is
Linear flters
For the linear flter
L
a
t
\
,

t
.
t-

C
where 4( m
j

L
~

u
j
is the trasfer fnction for the flter
.
j
=
+1
8.3 TIM SERES - BOX-JENKNS METHODOLOGY
4Z
Ljung and Box "portmanteau" test of the residuals for an
ARA(,q) model
m Z

r
k
Z
n(n + 2)

Xm-(p+q)
k=!
n-
k
where rk (k =1,2, . . . ,m) is the estimated value of the kth
autocorrelation coeffcient of the residuals ad n is the number of
data values used in the ARM(p,q) series.
Turning point test
In a sequence of n inde[endent random
v
aribles the number of
turing points T is such that:
E
(T
)
=
13(
n-2) a
nd
v
a(T
)
=
16
n-29
90
9 ECONOMIC MODELS
9.1 UTILITY THEORY
Utity functions
Exponential: U (w) = -e a > 0
Logarithmic: U(w) = logw
Power:
Quadratic:
Measures of risk aversion
Absolte risk a1ersiM.
Relative risk aversion:
A(w)
U"(w)
U'(W)
R(w) wA(w)
9.2 CAPITAL ASSET PRCING MODEL (CAPM)
Security market line
Capital market line (for efcient portfolios)
(
p
E
p
-r=(E
M
-r)
(
M
43
9.3 INTERST RTE MODELS
44
Spot rates and forard rates for zero-coupon bonds
Let PCt) be the price at time Oof a zero-coupon bond that pays I unit
at time 1.
Let s(1) be the spot rate for the period (0,1).
Let f(1) be the instantaneous forward rate at time Ofor time 1.
Spot rte
Instantaneousforward rate
P(1)
=
exp( -J; f(S)dS) or
Vasicek model
Instntaneous forward rate
Price ofa zero-coupon b ond
l_e-a'
where D(1) =
e
d
f(1) = --logP(1)
d1
1 1NANLA1O1HNA11V15
Note. In this section, Q denotes the (continuously-payable) dividend
rate.
10.1 PRCE OF A FORWA OR FUTURS CONTRACT
For an asset with fixed income o/ present value I:
F
|S
-J
)
e
r
T
For an asset with dividends:
F -
S
.-;)
-
e
10.2 BINOMIAL PRCING ("TREE") MODEL
Rsk-neutral probabities
-e
,
d
Up-step probability
e
-
,
u
-
d
+3
10.3 STOCHASTIC DIFFERNTIA EQUATIONS
Generalised Wiener process
d=adt+bdz
where a and :are constat and d is the increment for a Wiener
process (standard Brownian motion).
Ito process
d = a(x,t )dt + b(x,t)d
Ito's lemma for a function G(x,t)
dG= a-+-b -+- dt+b-dz
( dG 1
2
cPG aG] aG
ax 2
ax
2
at ax
Models for the short rate rt
Ho-Lee: dr = 8(t)dt + (d
Hul-Wite: dr = [OCt) - ar ]dt + (dz
Vasicek: dr = a(:-r )dt + adz
Cox-Ingersol-Ross: dr = a(b -r)dt + a.dz
10.4 BLACK-SCHOLES FORMULAE FOR EUROPEAN OPTIONS
46
Geometric Brownian moton model for a stock price St
Black-Scholes partial diferental equation
a
f
a
f 1 2 2
a
2
f
-+(r -q)S -+-( S -=t
at last
2
t
as?
Garman-Kohlhagen formulae for the price of call and put options
h d iog(St/K)+(r-q+IO
2
)(T
-
/)
were
*

and
OT

2
d
-
iog(
S
t! K) + (r -q -IO J(I-
t
) d
2
-

-

O\T
-
I
10.5 PUT-CALL PARITY RLATIONSHIP
K

,
,
-
S
-q(T-
t
)
Ct

e -Pt
*
te
+