Exam IFM Formula Sheet

Forwards and Futures

Pricing forwards: For currency options: Domestic risk-free Futures are marked-to-market. If the margin
F0,T = S0 erT − CumVal(Divs) rate serves as r; foreign risk-free rate serves as account falls below the maintenance margin,
δ. the broker makes a margin call to the investor
F0,T = S0 e(r−δ)T to provides funds to increase the margin
P = e−rT F
Prepaid forwards: F0,T account level to the initial margin level.
0,T

Option Strategies
With underlying assets: Ratio spread: long and short an unequal Strangle: long K2 call, long K1 put
number with different strike prices (K1 < S0 < K2 )
• Long put, long stock (floor)
• Long call, short stock (cap)

Payoff

Payoff
• Short call, long stock (covered written
call)
• Short put, short stock (covered
written put)
St St
Bull spread: long K1 , short K2 (K2 > K1 )
Collar: long K1 put, short K2 call (K2 > K1 )
Symmetric butterfly spread: long 1
K1 = K − c call, short 2 K2 = K puts, long 1
K3 = K + c put
Payoff

Payoff

Payoff
St
St

Bear spread: long K2 , short K1 (K2 > K1 ) Straddle: long K call, long K put (K = S0 )
St

Asymmetric butterfly spread: Long n bull

Payoff

Payoff

spreads (strikes K1 , K2 ) and m bear spreads

(strikes K2 , K3 ), with

n K3 − K2
=
m K2 − K1
St St

Put-Call Parity
Put-Call Parity equation: For stock, For exchange options,
−rT −rT
C(S, K, T ) − P (S, K, T ) = e (FT (S) − K) C − P = S0 − PV0,T (Divs) − Ke C(A, B) − P (A, B) = FTP (A) − FTP (B)
−rT −δT −rT
= FTP (S) − Ke C − P = S0 e − Ke C(A, B) = P (B, A) = receive A, give up B

Comparing Options
Bounds on option prices: 2. For dividend paying stocks, the PV of Different strike prices:
the dividends must exceed the lost
1. American options are worth at least as K3 > K2 > K1 . All options are for the same
interest: underlying stock and have the same time to
much as European ones. PVt,T (Divs) ≥ K 1 − e−r(T −t) .


2. A call option cannot be worth more than expiry.
3. Early exercise for put options may be
the underlying stock. A put option rational if CEur (St , K, T − t)
+ Direction:
cannot be worth more than the strike PV(Divs) − K 1 − e−r(T −t) < 0. C(K2 ) ≤ C(K1 )
price. European options cannot be worth
more than the present values of these. Time to expiry: P (K2 ) ≥ P (K1 )
3. An option must be worth at least 0. 1. An American option (or European call Slope:
4. European options are worth at least as option on nondividend paying stock) C(K1 ) − C(K2 ) ≤ K2 − K1
much as implied by put-call parity with expiry T and strike price K is
assuming the other option is worth 0. worth at least as much as one with P (K2 ) − P (K1 ) ≤ K2 − K1
5. American options are worth at least expiry t < T and strike price K.
Convexity:
their exercise value. 2. A European option on nondividend
paying stock with expiry T and strike C(K3 ) − C(K2 ) C(K2 ) − C(K1 )
Early exercise: ≥
price Ker(T −t) must cost at least as K3 − K2 K2 − K1
1. Early exercise is never optimal for call much with one with expiry t and strike P (K3 ) − P (K2 ) P (K2 ) − P (K1 )
options on nondividend paying stocks. price K. ≥
K3 − K2 K2 − K1
 Binomial Trees
Replicating portfolio: Buy ∆ shares, lend B In general, Futures: Use δ = r in all formulas except for
replicating portfolio formulas:
e(r−δ)h − d
 
Cu − Cd
∆= e−δh p∗ =
S(u − d) u−d

uCd − dCu

1 Cu − Cd
−rh = √ for forward tree ∆=
B=e F (u − d)
u−d 1 + eσ h
B=C
Risk-neutral probability: Premium:
For a forward tree, C = ∆S + B
√ √ For an infinitely lived call option on a stock
u=e (r−δ)h+σ h
,d = e(r−δ)h−σ h = e−rh (p∗ Cu + (1 − p∗ )Cd ) with σ = 0, exercise is optimal if Sδ > Kr.

Lognormal Distribution
The ratio St /S0 is a lognormal random variable
with parameters m = (α − δ − 0.5σ 2 )t and Pr(St > K) = N (dˆ2 ) PE[X | Y ]
√ E[X | Y ] =
v = σ t. Pr(Y )
Pr(St < K) = N (−dˆ2 )

ln(S0 /K) + (α − δ + 0.5σ 2 )t Expected option payoffs: Accumulate

dˆ1 = √ Black-Scholes premium, replace r with α:
σ t PE[St | St > K] = S0 e (α−δ)t
N (dˆ1 )
√
dˆ2 = dˆ1 − σ t PE[St | St < K] = S0 e(α−δ)t N (−dˆ1 ) Call: S0 e(α−δ)t N (dˆ1 ) − KN (dˆ2 )

Put: KN (−dˆ2 ) − S0 e(α−δ)t N (−dˆ1 ).

Black-Scholes Formula
General Black-Scholes Formula: For stock,

C(S, K, σ, r, T, δ) = F P (S)N (d1 ) − F P (K)N (d2 ) C = Se−δT N (d1 ) − Ke−rT N (d2 )

where P = Ke−rT N (−d2 ) − Se−δT N (−d1 )

ln F P (S)/F P (K) + 21 σ 2 T

where
ln(S/K) + r − δ + 12 σ 2 T


d1 = √
σ T d1 = √
√ σ T
d2 = d1 − σ T For futures, use δ = r.

Greeks
The only useful formula not on the formula The volatility of an option is For both the stock and the option, the Sharpe
sheet is ratio is
α−r
σoption = σstock |Ω| φ=
∆put = ∆call − e−δ(T −t) σstock
The risk premium of an option (letting γ be The Greek for a portfolio is the sum of the
Option elasticity is given by the rate of return on the option) is Greeks.

S∆ The elasticity for a portfolio is the weighted

Ω= γ − r = Ω(α − r) average of the elasticities.
C

Delta Hedging
Overnight profit on a delta-hedged portfolio To hedge Greek(s), buy assets such that the
We can use this to approximate market-maker
consists of (1) the change in the value of the Greek(s) for the entire portfolio are 0. profit as
option, (2) ∆ times the change in the stock The delta-gamma-theta approximation for − 12 Γ2 + θh + rh(∆S − C(S)) − δh∆S


price, and (3) interest. Overnight profit is 0 at a change in stock price  is
√
S ± Sσ h C(St+h ) = C(St ) + ∆ + 21 Γ2 + hθ

Exotic Options
Asian options: Compound options with strike x and expiry Exchange option to receive S in return for Q:
t1 are options on options:
• σ 2 = σS
2 + σ 2 − 2ρσ σ
Q S Q
Payoff Average Price Average Strike −rt1
CallOnCall − PutOnCall = C − xe • Use Q and δQ for K and r, respectively
Call max(0, S − K) max(0, ST − S)
CallOnPut − PutOnPut = P − xe−rt1 , Chooser options:
Put max(0, K − S) max(0, S − ST )  
where C and P are the prices of the strike V = C(K, T ) + e−δ(T −t) P Ke−(r−δ)(T −t) , t
Barrier options: assets (standard call and puts). Forward start options offering a call option
• Knock-in: goes into existence if barrier with strike price cSt at time t expiring at time
Gap options pay according to the strike price
is hit T:
K1 if ST is above (call) or below (put) the
trigger K V = Se−δT N (d1 ) − cSe−r(T −t)−δT N (d2 )
• Knock-out: goes out of existence if 2
barrier is hit − ln c + (r − δ + 12 σ 2 )(T − t)
• Use K1 in formula for C and P d1 = √
Parity: Knock-in option + Knock-out option = σ T −t
√
Ordinary option • Use K2 in formula for d1 d2 = d1 = σ T − t
 Actuarial Applications of Options
Variable Annuities: The insurance company receives the proceeds • Shout options: The purchaser “shouts”
of the foreclosure sale. on a date where the price is S ∗ . The
• Guaranteed minimum death benefit payoffs of shout options are
(GMDB): guarantees a minimum Guaranteed replacement cost coverage is
amount (usually the premium), a rider to a property insurance contract that – Shout call option:
regardless of the account value, upon provides for paying the replacement cost for the max(0, ST − K, S ∗ − K)
death property rather than the actual cash value
before the loss. – Shout put option:
– Earnings-enhanced death benefit: max(0, K − ST , K − S ∗ )
Inflation indexing: Let I be the CPI. For an
pays a percentage of the excess of
indexed pension, • Rainbow options: For two assets S, T ,
the account value over the
premium Pt = max (P0 × (Is /I0 )). the payoffs of rainbow options are
0≤s≤t
• Guaranteed minimum accumulation – Rainbow call option:
benefit (GMAB): guarantees a minimum Static hedging: max(0, ST − K, QT − K)
value for the account at a specific time
• Lookback options: Let M be the – Rainbow put option:
• Guaranteed minimum withdrawal benefit maximum price of the underlying over max(0, K − ST , K − QT )
(GMWB): guarantees that after a the option period and m the minimum
policyholder reaches a specified age, he price. The payoffs of lookback options Hedging catastrophe risk
may withdraw a certain amount every are
year for life • Reinsurance
– Standard lookback call: ST − m
• Guaranteed minimum income benefit • Weather derivatives pay based on
(GMIB): guarantees a whole life annuity – Standard lookback put: M − ST whether a defined weather event occurs
purchase rate at specified ages – Extrema lookback call: • Catastrophe bonds pay (higher) interest
Mortgage guaranty insurance is purchased max(M − K, 0) and principal, but the the company is
by the lender and pays the lender the – Extrema lookback put: allowed to default if a catastrophe
outstanding loan balance plus settlement costs. max(K − m, 0) occurs.

Project Analysis
Downside semi-variance: Tail value-at-risk:
2
= E[min(0, (R − µ))2 ]
R VaRα (x)
σSV xf (x)dx
−∞
n TVaRα (x) = (downside)
2 1X α
σ̂SV = min(0, (Ri − R))2 R∞
n i=1 VaRα (x) xf (x)dx
TVaRα (x) = (upside)
1−α
Value-at-risk:
−1
VaRα (X) = FX (α)

Monte Carlo Simulation

−1
Inversion method: For a uniform number u ∈ (0, 1) and a random variable X, we can generate a random sample with x = FX (u).

Efficient Markets Hypothesis

Form Prices reflect Evidence

Weak Past information Stock prices follow random walk
Semi-strong The above, and all publicly or easily available information Takeover announcements reflected immediately in price
Strong The above, and private, hard-to-get, or hard-to-interpret Most fund managers don’t beat the market
information

Mean-Variance Portfolio Theory

Estimating volatility: Estimating covariance (j is the year): For an equally weighted portfolio,
P 1 n−1
(R1j − R1 )(R2j − R2 ) Var(R) = AvgVar + AvgCov
Cov(R1 , R2 ) = n n
n−1
(Ri − R)2
P
P 
σ2 = n R1j R2j Volatility of a portfolio:
n−1 = − R1 R2
P 2  n−1 n n
n Ri
X
2 P σP = xi ρP,i σi
= −R R1j R2j − nR1 R2
n−1 n = i=1
n−1
P 2 2
Ri − nR Sharpe Ratio:
=
n−1 Variance of a portfolio (xi are the weights): α−r
φ=
σ
n X
n
The most efficient portfolio is the one with the
X
Var(R) = xi xj Cov(Ri , Rj )
Standard error of sample mean: √σ highest Sharpe ratio.
n i=1 j=1
 Capital Asset Pricing Model
Beta of investment i with respect to portfolio P (or the market, if P is Fundamental approach to calculating market return:
not specified):
Div1
RM kt = +g
P Corr(RP , Ri ) SD(Ri ) Cov(RP , Ri ) P0
βi = =
SD(RP ) Var(RP )
Debt cost of capital:
Required return for investment i with respect to portfolio P :
rd = (1 − p)y + p(y − L) = y − pL
E[Ri ] − rf > φP SD(Ri ) Corr(Ri , RP )
where p is the probability of default, the proportion of loss upon default
= βiP (E[RP ] − rf ) is L, and the annual effective interest is y
Beta of portfolio in terms of its assets with weights xi : Unlevered cost of capital:
X E D
βP = xi β i rU = rE + rD
E+D E+D
Capital Market Line: expected return of efficient portfolio vs. Unlevered beta:
volatility
E D
Security Market Line: Expected return of investment vs. beta βU = βE + βD
E+D E+D

Arbitrage Pricing Theory

Arbitrage Pricing Theory Equation: Fama-French-Carhart factor specification:
N
X
βsF n E[RF n ] − rf


E[Rs ] − rf = E[Rs ] = rf + βsM kt E[RM kt ] − rf + βsSM B E[RSM B ]


n=1
+ βsHM L E[RHM L ] + βsP R1Y R E[RP R1Y R ],
With self-financing portfolios:
N
E[Rs ] =
X
βsF n E[RF n ] where SMB is the small-minus-big portfolio, HML is the high-minus-low
portfolio, and PR1YR is the prior year portfolio.
n=1

Capital Structure
Perfect Capital Market: WACC: Approximate required NPV for equity
E D holders to benefit for an investment of I:
1. Competitive prices are available to all. rWACC = rE + rD (1 − τC )
D+E D+E NPV βD D
2. Transactions are efficient.   >
D I βE E
3. Capital structure provides no = rpretax WACC − rD τC
D+E
information. Leverage ratchet effect: Presence of debt
Indirect costs of bankruptcy: leads to issuing more debt.
Modigliani-Miller:
1. Loss of customers Agency benefits:
In a perfect market,
2. Loss of suppliers 1. Control of company in fewer hands.
I. Capital structure does not affect firm
3. Loss of employees 2. Management has greater share of equity,
value.
4. Loss of receivables discouraging waste.
II. Cost of equity capital rises with leverage.
5. Fire sale of assets 3. No empire building.
Cost of equity capital:
6. Inefficient liquidation 4. Management more likely to be fired in
D 7. Costs to creditors financial distress.
rE = rU + (rU − rD )
E 5. Financial distress may lead to wage
Equity beta: Trade-off theory: concessions.
D V L = V U + PV(tax shield) 6. More incentive to compete.
βE = βU + (βU − βD )
E − PV(financial distress costs)
Credibility principle: Actions speak louder
− PV(agency costs) than words, when the words are in self-interest.
Interest tax shield: iDτC
+ PV(agency benefits)
Present value of interest tax shield: Adverse selection: Sellers with private
information sell the least desirable items.
V L = V U + PV(Interest Tax Shield) Asset substitution problem: Companies in
distress substitute risky assets for non-risky Lemons principle: Buyers discount price
V L is computed at the WACC and V U is ones. when seller has private information.
computed at the pretax WACC. Debt overhang: Companies do not make Pecking order hypothesis: Management
For permanent debt D, the present value of the positive-NPV investments because only prefers to finance first with retained earnings,
interest tax shield is DτC . creditors will benefit. then with debt, and only finally with equity.

Equity Financing
Pre-money valuation: value of the company before the funding round based on the price per share of the new series
Post-money valuation: value of the company after the funding round based on the price per share of the new series
Terms in financing agreements:

1. Liquidation preference: Minimum amount required if company is liquidated

2. Seniority: Get paid before earlier series, unless the series is pari passu
3. Participation rights: A clause may allow both participation in common stock dividends and liquidation preference.
 4. Anti-dilution protection: If the funding round is a down round (price per share drops),
• Full ratchet protection: Lowers conversion price to price of new series
• Broad-based weighted average protection: The new conversion price is the old conversion price times
Value of old shares at previous price + Cash received
Value of old shares and new shares at previous price

5. Board membership

Debt Financing
Public debt: 3. Treasury bonds: Semiannual coupons, terms greater than 10
years
1. Notes: unsecured, with terms less than 10 years
4. TIPS: Fixed coupon rates based on the inflation-adjusted
2. Debentures: unsecured, with terms of 10 years or more principal, maturity value equal to the higher of the original face
3. Mortgage bonds: secured by real property amount and the inflation-adjusted face amount
4. Asset-based bonds: secured by assets other than real property
Municipal bonds: Debt issued by state and local governments. They
International bonds: are exempt from federal taxes (and the issuing state usually exempts
them from its income tax)
1. Domestic bonds: issued domestically in local currency
1. General obligation bonds: payable from “full faith and credit” of
2. Foreign bonds: issued locally by a foreign company in local
the issuer
currency (Known as Yankee bonds in the U.S.)
3. Eurobonds: not denominated in the currency of the country in 2. Revenue bonds: payable from specific revenue bonds
which they are issued 3. Double-barreled bonds: general obligation bond with a provision
4. Global bonds: sold in many countries simultaneously, each in its to set aside a particular revenue source
own currency
Asset-based securities:
Private debt:
• Mortgage backed securities:
1. Term loans: loans by a bank or group of banks (usually
investment grade) – Ginnie Mae: Government National Mortgage Association,
explicitly guaranteed by the U.S. government
2. Private placements: loans by a small group of investors
– Fannie Mae: Federal National Mortgage Association
Sovereign debt: Debt issued by national governments. U.S.
– Freddie Mac: Federal Home Loan Mortgage Corporation
Treasuries are exempt from state and local taxes.
• Sallie Mae: Student Loan Marketing Association
1. Treasury bills: No coupons, terms 1 year or less
2. Treasury notes: Semiannual coupons, terms over 1 year but no Debts from asset-based loans can be packaged into collateralized debt
more than 10 years obligations (CDOs), with different tranches with different priorities.

Real Options
Option to wait is a call option. Option to abandon is a put option.
Expenses during the year of waiting, or lost income, are treated as Beta for an option with elasticity Ω is
dividends. Free cash flows generated if the company does not wait is
also a dividend, but discounted at the cost of capital rate. βoption = Ωβstock