FTM Summary

Agnes Lieftinck
October 30, 2015

Returns

Gross/Total Return
R=

X1
X0

(Net) Return
r=

X1 X0
X0

Log Returns
For small changes, log returns are almost equal to normal returns. Calculations
on portfolios require normal returns.

Portfolio Returns
Pn
i0
Portfolio weight: wi = X
i=1 Xi0 = 1
X0 , with
Note wi < 0 is possible and corresponds to shorting.
X
r=
wi ri
X
R=
wi Ri

Portfolio Mean & Variance

P
E[r] = wi E[ri ]
ij = E[ri E(ri )][rj E(rj )]

Portfolio Variance
P
2 = i,j wi wj ij
Note that for i 6= j we have the covariance between i and j. For uncorrelated
stocks this variance/risk can be diversified away (zero covariance). When stocks
are correlated this corresponds with systematic risk and we can not get rid of
it.

Markowitz Mean-Variance

Minimize
2 =

wi wj ij

i,j

Subject to
X
r=
wi ri
X
wi = 1
Set upP
Lagrangian
P
P
L = 12 i,j wi wj ij ( wi E[ri ] r) (1 wi )
F.O.C.
P
j ij E[ri ] = 0i
jw
P
rP= wi ri
wi = 1
With a shortselling constraint you need to include wi > 0i. For the solution
of this problem, software is needed.

Two-Fund Separation
If the Markowitz problem has two distinct solution, any linear combination of
them is a solution as well. All combinations together draw the efficient frontier.

One-Fund Theorem
There exists a single fund F of risky assets such that any efficient portfolio can
be constructed as a combination of F and the risk-free asset.
r = ar1 + (1 a)r2

Sharpe Ratio
r r

tan = pp f
Maximizing this yields the unique optimal portfolio.
max

E[ri ] rf
w i qP
i,j wi wj ij

P
Solution: i vi ij = E[rj ] rf j and wi = Pvivj
j
Drawbacks of this method are that the market is volatile and hence you will
always have a large standard error. This method is suited for small sets of
assets.

CAPM

The optimal fund of the One-Fund Theorem should be the market portfolio. The
weights in this portfolio equal the capitalization weights. You let the market
solve the Mean-Variance problem for you and just follow the market. Eventually
prices and thus returns adjust to the equilibrium.
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If market portfolio M is efficient, then

E[ri ] rf = i (E[rM ] rf )
with i = iM
2
M
The beta of an asset gives that its return is proportional to its covariance with
the market return.
E[ra ] = aE[ri ] + (1 a)E[Rm ]
q
2
a = a2 i2 + 2a(1 a)iM + (1 a)2 M
E[ra ]
= E[ri ] E[Rm ]
a
2
E[a ] ai2 + (1 2a)iM (1 a)M
p
2
a
a2 a2 + 2a(1 a)iM + (1 a)2 M
Then for a = 0
2
E[a ]
iM M
=
a
M
The slope of this curve in a = 0 should be the slope of the CML

(E[ri ] E[Rm ])M

E[ra ]
=
2
E[a ]
iM M
E[Rm ] rf
=
M
E[Rm ] rf
(E[ri ] E[Rm ])M
=
2
iM M
M
E[ri ] E[Rm ] =
E[ri ] E[Rm ] =
E[ri ] E[Rm ] =
E[ri ] =

2
)(E[Rm ] rf )
(iM M
2
M

iM
2 (E[Rm ] rf )
M
2
2
M (E[Rm ] rf )
M
iM
2 (E[Rm ] rf ) (E[Rm ] rf )
M
iM
rf + 2 (E[Rm ] rf )
M

With i = iM
2 .
M
The risk that is priced is measured by . is only important for the entire
portfolio.
Negative betas exist, they do well when markets go down. Example; you pay
for insurance. You pay for an asset that reduces your portfolio risk.
Fund that lies above the Capital Market Line; either the fund outperforms the
market, or your model of the market was wrong.

Using CAPM for pricing

Q
If a firm is expected to be worth Q in a year, then its fair price P = 1+rf +i (E[r
.
M ]rf )
The denominator is called the cost of capital.
Q2
1
Note that for P1 = 1+rf +1Q
(E[rM ]rf ) and P2 = 1+rf +2 (E[rM ]rf ) we have

P1 + P2 =

Q1 +Q2
1+rf +1+2 (E[rM ]rf ) .

Certainty Equivalent Pricing Formula

Pi =



1
cov(Qi , rM )[E[rM ] rf ]
Qi
2
(1 + rf )
M

Factor Models

Single Factor Models

Assume E[ei ] = 0, E[ei ej ] = 0, E[(f E[f ])ei ] = 0
ri (t) = ai + bi f (t) + ei (t)
E[ri ] = ai + bi E[f ] + E[ei ]
= ai + bi E[f ]
i2

= var[ai + bi E[f ] + E[ei ]]

2
= b2i f2 + ei

ij = cov(ai + bi E[f ] + E[ei ], aj + bj E[f ] + E[ej ])

= bi bj f2
This way of model estimation requires way less parameter estimations. The
more assets, the more this is an advantage.

Portfolio Parameters for Factor Models

r=

wi ai +

wi bi f +

wi ei

r = a + bf + e
X
a=
wi ai
X
b=
wi bi
X
e=
wi ei
E[e] = 0
ei = 0
X
var[e] =
wi2 i2
1 2
S
n
E[ei ej ] = 0
=

var[r] = b2 f2 + e2
Risk due to ei is diversifiable, nonsystematic. Risk due to f is systematic and
can not be diversified away.

Multifactor Models and their Moments

ri = ai + b1i f1 + b2i f2 + ei
E[ri ] = ai + b1i E[f1 ] + b2i E[f2 ]
var[ri ] = b21i f2 1 + b22i f2 2 + 2b1i b2i cov(f1 , f2 ) + e2
cov(ri , rj ) = b1i b1j f2 1 + b2i b2j f2 2 + (b1i b2j + b2i b1j )cov(f1 , f2 )
cov(ri , f1 ) = bi1 f2 1 + bi2 f 1,f2
cov(ri , f2 ) = bi2 f2 2 + bi1 f 1,f2
There are three factor groups; External (unemployment rate, GDP), Extracted
(portfolios that replicate an external phenomena) and Firm Characteristics.

Arbitrage Pricing Theory

ri = ai + bi f
rj = aj + bj f
r = wai + (1 w)aj + (wbi + (1 w)bj )f
bj
w=
bj bi
aj bi
ai bj
+
+0f
r=
bj bi
bi bj
The return is risk free since it does not depend on f . The return must thus be
equal to the risk-free rate. bi and ai are dependent! Now take 0 is this risk-free
return.
ai 0
aj 0
=
bi
bj
ak 0
=
bk
=c
E[ri ] = ai + bi E[f ]
= 0 + bi c + bi E[f ]
1 = c + E[f ]
E[ri ] = 0 + bi 1
For multiple factors we have up to n . Each is called the factor price/price
of risk.
In a well-diversified portfolio with error-terms, n gives e2 0. Hence for
large, well-diversified portfolios we can ignore the error-term.

Data & Statistics

1+ry = (1+r1 )(1+r2 )...(1+r12 ) and if ri is small, 1+ry 1+r1 +r2 +...+r12 .
P12
P12
Then E[ry ] = 12E[ri ] and y2 = E[ i=1 (ri E[ri )]2 ] = E[ i=1 (ri E[ri ])2 ] =
12 2 .

1
E[ry ] and = 112 y . Generally, E[ri ] = pE[ry ] and = py .
Note E[ri ] = ( 12
5

Mean Blur
Lower frequency aka higher p makes ration better but reduces number of observations. Higher frequency aka lower p works the other way around. More
data usually gets you a more precise estimate. For the estimation of 2 a higher
frequency does help, since the relative error is small for large n.

Multiperiod Fallacy
MV keeps reusing the same weights and parameters, though prices change over
the periods.

Utility

Arrow-Pratt
Absolute risk-aversion coefficient
U 00 (x)
U 0 (x)
xU 00 (x)
rra(x) =
U 0 (x)

ara(x) =

How to interpret rra? It determines the risk premium in terms of a multiple of

variance.

Certainty Equivalent
U (C) = E[U (x)]

Linear Pricing

Type A Arbitrage
Selling price of 2 apples is higher than the buying price of two separate apples;
buy one and one, sell the two together, make a profit. If the price of two apples
is lower than that of the separate ones, buy the two and sell them separately to
make a profit.
Since this can notPhappen, we conclude P
pricing is linear. That is, the price
of a portfolio d =
wi di should be P =
wi Pi .

Type B Arbitrage
Free lottery ticket; no initial cost, yet change of (only) positive pay-off.

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Optimal Portfolio

Can only exist if there is no arbitrage, since if there is, you can make boundless
money with which you can expand your portfolio.
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Set up a Lagrangian;
X
X
max L = E[U (
wi di ) (
wi Pi W )]
where W is initial wealth
For the optimal portfolio we must have E[U 0 (x)di ] = Pi i
If there exists a risk-free asset, is easy to obtain since the risk-free asset has
price 1 and certain pay-off of R. This gives
E[U 0 (x)]R =
Pi =

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E[U 0 (x)di ]
E[U 0 (x)]R

Finite State Models

If there exists a complete set of state securities es (one for P

each state), then
any security d = {d1P
, d2 , ..., dn } can be expressed as d =
ds es . Thus its
s
d s . Use state securities as building blocks for other
price should be P =
securities.

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Risk Neutral Pricing

P =

ds s

0 =

qs =

s
0

P = 0

ds qs

P = o E[d]
0 is the price of the risk-free asset since it is the price of (1, 1, ..., 1).

This gives us P = R1f E[d],

the risk neutral pricing.
Construct risk neutral probabilities by 1) multiplying state prices by the risk-free
0
P
1
s U (x)
rate, 2) form a portfolio problem (qs = P p(p
qs dsi
0 (x)t ), 3) solve Pi = R
U
t
t
(only if number of states matches number of securities).

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Binomial Lattice Tree

Choosing Parameters
v is the expected yearly growth rate
v = E[ln( SST0 ]
is the yearly standard deviation
2 = var[ln( SST0 ]
For period t

p = 21 + 12 v t

u = exp(
t)
d = exp( t)
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Multiplicative Model

Many possible outcomes, represented by a random variable.

S(t + 1) = u(t)S(t)
ln(S(t + 1)) = ln(u(t)) + ln(S(t))
w(t) = ln(u(t)) N (v, 2 ) t
Thus u(t) = exp(w(t)) is lognormal.
S(t) = u(t 1)u(t 2)...u(0)S(0)
X
ln(S(t)) =
ln(u(i)) + ln(S(0))
X
= ln(S(0) +
w(i)
E[ln(S(t))] = ln(S(0)) + vt
var[ln(S(t))] = t 2
Hence both grow linearly with t. Real stock distributions are close to lognormal,
but have fatter tails.
Estimate parameters:
1 ln(S(T )
T S(0)
S(t + 1)
1 X
(
ln(
) v)2
2 =
T 1
S(t)
2
var[
v] =
T
2 4
var[2 ] =
T 1
v =

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Random Walk

z(tk+1 ) = z(tk ) + (tk ) t

tk+1 = tk + t
(tk ) N (0, 1), i.i.d.
E[(tk )(tj )] = 0
X

z(tk ) z(tj ) =
(ti ) t
i
k1
X

E[z(tk ) z(tj )] = E[

(ti ) t]

i=j

k1
X

E[(ti )]

i=j

=0
X
p
(ti ) t)2 ]
var[z(tk ) z(tj )] = E[(
i

k1
X

E[((ti ) t)2 ]

i=j

k1
X

E[(ti )2 t]

i=j

k1
X

tE[((ti )2 ]

i=j

= (k j)t
= tk tj
z(tk ) z(tj ) N (0, tk tj )

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Wiener Process/Brownian Motion

(0, t s).
For any s<t, z(t) z(s)N
z(t0 ) = 0
Same properties as Random Walk, though not limited to discrete time intervals.
Thus we get:

z = (t) t

dz(t) = (t) dt

Generalized Wiener Process

dx(t) = adt + bdz, a and b constant.

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Ito Process

dx(t) = a(x, t)dt + b(x, t)dz

a(x, t) is called the drift term, b(x, t) is called the diffuse term.
dlnS(t) = vdt + dz with z is a Wiener process.
lnS(t) = lnS(0) + vt + z(t) which is a geometric Brownian Motion., which is
N (lnS(0) + vt, 2 t).
This means S(t) is lognormally distributed, hence S(t) = S(0)exp(vt + z(t))
and E[S(t)] = S(0)exp()t.

Standard Ito Form

dS(t)
= dt + dz
S(t)

Itos Lemma
If
dx(t) = a(x, t)dt + b(x, t)dz
y(t) = F (x(t))
dy(t) = (

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F
1 2F 2
F
F
a+
+
b )dt +
bdz
2
x
t
2 x
x

Options

Whether its a call or put, expiration/maturity date, strike price and the premium, including whether it is an American or European option.
For strike price K and asset price S we have
C = max(0, S K)
P = max(0, K S)
If your option would yield a positive pay-off given the current asset price, your
option is said to be in the money. Alternatives are at the money (strike price
equals current asset price) and out of the money.

Put-Call Parity
CT PT = max(0, ST KT ) max(0, KT ST )
= ST KT
Ct Pt = St Kt
= St P V (Kt )
Remember that shorting an option means that its value is negative to you at
expiration date, because that is the value you need to redeem. The put-call
parity holds only for European options and if dividends are not paid out before
expiration.
The parity states that buying a call and shorting/writing a put is equivalent to
buying the stock and borrow the PV of strike price K.

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Risk-neutral Probabilities
(Pup Pnow ) + (1 )(Pdown Pnow )
= rf
Pnow
Here is the risk-neutral probability.

American Puts; early exercise

If the continuation value is lower than exercising immediately, you should exercise early. however, this is risky. By holding on to your option longer you could
make a bigger profit (i.e. if the price of the stock descends even further), or you
could miss your chance (the price could go up again). The maximal profit is
when S = 0.

In the Tree
Use risk-neutral probabilities.

P = E[

dk fk ]

Where dk is the risk-free discount factor at node k andPfk is the pay-off at node

fk ].
k. Then if d does not depend on k we have P = R1 E[

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Black-Scholes Equation

The price of a stock is governed by a Generalized Brownian Motion;

dS = Sdt + Sdz
The value of a risk-free bond carrying interest rate r is governed by;
dB = rBdt
S has a derivative, whose price is a function of S and t, that is f(S,t).
Then
f
f
1 2 2 2
+
rS +
S = rf
t
S
2 S 2
Any derivative of a stock should satisfy this equation!

Boundary Conditions
Stock: f(S,T) = S(T)
Bond: f(S,T) = exp(rT)
Call: f(S,T) = C(S,t), C(0,t) = 0 and C(S,T) = max (S-K,0)
Put: f(S,t) = P(S,t), P(,t) = 0, P(S,T)=max(K-S,0)

Black-Scholes Call Option Formula

C(S, t) = SN (d1 ) Kexp(r(T t))N (d2 )
d1 =

S
[ln K
+ (r + 12 2 )(T t)]

( T t)

S
+ (r 12 2 )(T t)]
[ln K

( T t)

= d1 T t

d2 =

11

(1)

When T=t, d1 = d2 = for S>K and d1 = d2 = for S<K. This yields

N (d1 ) = N (d2 ) = 1 for S>K and N (d1 ) = N (d2 ) = 0 for S<K.
Hence C(S,T) = S-K if S>K and C(S,T)=0 if S<K

Risk Neutral Valuation

dS = Sdt + dz
E[S(t)] = S(0)exp(t)
r
dw =
dt + dz

z(t) N (0, t)
r
w(t) N (t
, t)

dS = rSdt + Sdw

E[S(t)] = S(0)exp(rt)

S(0) = exp(rt)E[S(t)]

C = exp(rt)E[max{S(T
) K, 0}]
1
S(T )
] = rT 2 T
S(0)
2
S(T )
] = 2 T
var[ln
S(0)
Z K
Z

E[max(S(T
) K, 0)] =
0S(T )dS(T ) +
E[ln

S(T )dS(T ) K

dS(T )
K

This equals the Black-Scholes formula in integral form.

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Delta, Gamma, Theta

(S,t)
f
S
= fS
For a call option = N (d1 ). Delta can be used for hedging, it is a measure for the optimal amount to invest in stocks. We can calculate our portfolio
delta, which is the sum of each components own delta. Keeping a portfolio delta
neutral requires constant rebalancing of the portfolio because prices change constantly; dynamic hedging strategy.

2 f (S,t)
S 2 ,

curvature

(S,t)
= f t
f S + (S)2 + t
This is an approximation of the Black-Scholes Equation.

Basic Strategy in Arbitrage Pricing

Replicate the derivative security. Do this by constructing a self-financing portfolio consisting of the underlying asset and the risk-free asset. This is called
a synthetic derivative. Usually requires continuous rebalancing. If there is no

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arbitrage, the real and synthetic security should have the same price.
Portfolio insurance is the creating of synthetic put options.

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